What the 'Melt Down' Could Look Like

More on the canary in the bond market coalmine... Major warning signs emerge... One important 'trigger' is missing... Is this time different?... What the 'Melt Down' could look like...

Regular Digest readers know the 'canary' in the bond market 'coalmine' has finally succumbed...

Of course, we're referring to bankrupt toy retailer Toys "R" Us, which announced last week it was shuttering all of its remaining stores and liquidating its assets.

But this isn't the only major warning sign from the credit markets of late. As our colleagues Mike DiBiase and Bill McGilton explained in the latest issue of Stansberry's Credit Opportunities, published last evening...

Another industry giant – radio-station owner iHeartMedia – filed for Chapter 11 bankruptcy protection last week. The company, which owns about 850 stations, can no longer afford its roughly $1.8 billion in interest payments. It wants to cut its $20 billion of debt in half.

Two of the strongest companies in their industries succumbed to the weight of their own debt. That's not a good sign for similarly overleveraged companies.

The bloodshed spilled over into this week... On Monday, jewelry chain Claire's – which has been a fixture at malls and shopping centers for 40 years – filed for Chapter 11 bankruptcy protection. The company hopes to free itself of $1.9 billion in debt and close some stores.

More high-profile bankruptcies are likely coming... especially in the ravaged retail sector.

Yet despite these obvious signs of trouble, one important crisis 'trigger' is missing...

The high-yield corporate default rate remains unusually low today.

In fact, as Mike and Bill noted, the usual relationship between corporate debt and corporate defaults has broken down in recent years...

Many investors point to the fact that high-yield default rates are still low – around 2.5%. The average historical default rate is around 4%... And it spikes above 10% during credit crises...

Today, total corporate debt in the U.S. sits at a record $9 trillion. That's more than before the last financial crisis, both nominally and as a percentage of gross domestic product (GDP). The massive increase in corporate debt and falling default rates is highly unusual...

Historically, these two statistics have moved up and down together. That makes sense... In periods when total corporate debt rises, so does the amount of defaults. But the relationship broke down in 2012 for a period... And then again in 2016. Corporate debt continued to rise... yet the default rate fell from more than 5% to around 2.5% today. It's unnatural for these two metrics to move in opposite directions.

This following chart from ratings firm Moody's Analytics puts this unusual divergence in perspective...

As you can clearly see, rising corporate indebtedness has been predictably followed by rising corporate defaults for at least the past few decades. But that relationship has changed in the years following the 2008/2009 financial crisis.

We can't say for certain why this occurred... though we suspect it may have something to do with the unprecedented central-bank stimulus and record-low interest rates we've seen since the crisis.

But unless you believe that "this time is different" – and we certainly don't – the outcome isn't in question.

It's simply a matter of time before the default rate rises dramatically. And as Mike and Bill explained, the recent rise in interest rates suggests the clock is already ticking. More from the issue...

Interest rates on five-year and 10-year U.S. Treasury notes have more than doubled since July 2016. As these rates rise, corporations are charged higher interest rates on new loans.

That means the outstanding debt will only become more expensive when these companies attempt to refinance in the coming years.

You can probably guess how it's going to end... Defaults will rise, and the weight of the debt will become too large. When these defaults reach a critical mass, it will trigger the next credit crisis. Massive amounts of debt will be wiped out.

The storm is on its way.

To be clear, this doesn't mean the 'storm' will arrive tomorrow...

Take another look at the chart above. You'll also see that the high-yield default rate has typically started rising months or even years in advance of the eventual crisis.

Today, despite the warning signs in several corners of the high-yield credit markets, the broad default rate remains historically low. This chart suggests significant trouble is unlikely until this rate moves higher.

In short, while we remain vigilant for evidence to the contrary, history suggests Steve Sjuggerud's "Melt Up" will continue.

Of course, even Steve himself admits we're in the final 'inning' of this long bull market...

And while he predicts the Melt Up could run for another couple years under the best-case scenario, he also believes it's time to start preparing for the "Melt Down" to follow.

Why? Because Steve believes the key to successful long-term investing is your starting point. And as he explained in the March issue of True Wealth – published last Friday – the starting point in U.S. stocks today isn't great...

You might be shocked to hear this, but based on our starting point, U.S. stocks may deliver no return – or even a negative return – for the next decade or even longer.

As Steve noted, this isn't a hypothetical. We've only seen a similar starting point in U.S. stocks two other times in the past 100 years. And each was a terrible time for long-term investors...

What happened last time? It's not good... The only other time stocks went up nine years in a row was during the 1990s. That ended badly – with the dot-com bust. The Nasdaq Composite Index lost 80% of its value from peak to trough. If you bought at the dot-com peak, it would have taken you 14 years to break even.

U.S. stocks had eight consecutive winning years (a similar time frame) during the Roaring Twenties... Then the Great Depression hit. And stocks lost money in nine out of the next 13 years.

If your starting point for buying U.S. stocks was the peak in 1929, then you wouldn't have broken even until 1946, based on the S&P 500 Index.

So what could the Melt Down look like this time around?

Steve shared a conservative forecast from legendary investor Jeremy Grantham...

Using Grantham's seven-year forecasts for U.S. stocks and bonds (at GMO.com), you're looking at a real return of -3.6% per year over the next seven years in the stock market.

This -3.6% return isn't based on unreasonable assumptions. Grantham only assumes "reversion to the mean." Based on that, Grantham expects large U.S. stocks will return -5.5% a year for the next seven years. And U.S. bonds will return -0.5%. Combine those in the classic 60% stocks/40% bonds portfolio mix, and you end up with a -3.6% return per year for seven years...

If our starting point is bad today, are you willing to accept 14 to 17 years of no return on stocks like we saw after 1929 or after 2000?

Unless you're a masochist, we'll assume your answer is 'no'...

In which case, Steve says you must be prepared to adjust your investment approach over the next several years. As he explained...

We need to do something different... Our simple plan for the next seven years is to:

• Keep riding the "Melt Up" for another 18 months – at least.
• Then shift gears completely, and get more conservative.
• Invest in alternatives to traditional stocks and bonds. And,
• Find "tactical" trades that can make money on a shorter-term basis.

Again, Steve isn't turning bearish yet...

He believes the Melt Up has further to run... And the most explosive gains are likely still ahead.

But he is also beginning to look for these shorter-term "tactical" opportunities – trades that can make you money no matter what happens in the broad market – as a hedge. And he found an incredible one this month...

In short, it's a simple way to exploit one of the biggest fears among investors today – rising interest rates – and make up to 50% in the next three to six months.

It wouldn't be fair to Steve's paid-up subscribers to share all the details here today. But you can get instant access to this recommendation with a 100% risk-free trial to True Wealth. Click here to get started now.

New highs (as of 3/21/18): none.

Another hectic day in the markets. How is your portfolio holding up? Let us know at feedback@stansberryresearch.com.

Regards,

Justin Brill
Baltimore, Maryland
March 22, 2018