Why the Next Recession Could Be Closer Than Expected

The Fed is in trouble... Why the next recession could be closer than expected... It's official: 'Quantitative tightening' is bad for stocks... Keep an eye on junk bonds now...

Today, the Federal Reserve finds itself between 'a rock and a hard place'...

As regular Digest readers know, the Fed is now raising interest rates and unwinding its unprecedented stimulus program for the first time since the 2008 financial crisis.

The short-term Fed funds rate currently sits at 2%, versus as little as 0% just a few years ago... and quantitative easing has been replaced by quantitative tightening.

In short, the financial "tide" that helped push assets prices higher over the past several years is now rolling out.

The Fed is doing this for two key reasons...

First, it fears leaving these radical measures in place too long could trigger an inflationary spiral.

Second, and perhaps more important, the "clock" is already ticking on the next recession. The Fed is worried that if it doesn't "tighten" now, it won't have room to ease again when the next downturn arrives.

Unfortunately, history suggests removing this stimulus is likely to hasten its arrival. In fact, as we noted back in March, the Fed has an unblemished track record of "success" in this area: Virtually every tightening cycle in its 105-year existence has ended in recession (or worse).

But it appears the Fed's odds are worse than ever...

You see for the past several decades, each of the Fed's tightening cycles has ended earlier than the last. Like an addict requiring larger and larger amounts of a drug simply to feel "normal," the economy has become more and more dependent on easy money.

For example, in the late 1980s, the Fed was able to raise short-term interest rates to nearly 10% before triggering a recession.

During the late 1990s dot-com boom, the Fed raised rates above 6.5% before the economy rolled over.

And most recently in the mid-2000s, the Fed made it to only 5.25% before the housing bubble burst and set off a crisis.

Despite the Fed's unprecedented stimulus following the last crisis, the latest recovery has been the weakest yet. If this trend continues, it's possible the next downturn could begin with short-term rates below 4%... or even 3%.

Again, the Fed Funds rate is currently 2%, and the Fed expects to increase it two more times to 2.5% or more by year end.

In the meantime, we're already seeing potential signs of trouble...

As we noted last week, the Fed's quantitative tightening program has been relatively modest so far. Since beginning to reduce its $4 trillion-plus balance sheet in October, the Fed has "run off" a little more than $110 billion.

That's because the Fed started at a rate of just $10 billion per month, and has slowly increased it by an additional $10 billion per month each quarter.

This month, the rate jumps again to $40 billion per month... meaning the Fed will run off more over the next three months than it has to date. And it's then set to jump one more time to $50 billion per month in October.

In other words, the 'tide' is about to become much more powerful...

Yet, despite the relatively small size of this program to date, it has already had a dramatic effect on the markets. As Bloomberg reported last week...

Quantitative tightening days haven't been kind to the S&P 500 Index lately. The U.S. equity benchmark has stumbled on the last five occasions the Federal Reserve System Open Market Account has had Treasuries mature...

Each maturity date since Feb. 28 has coincided with a drop of 0.68% or more in the S&P 500 Index. The March 31 roll-off was followed by a 2.2% plunge the next trading day, the fourth-worst session for the index this year.

Meanwhile, an important credit-market 'divergence' appears to be closing...

As regular readers know, investment-grade corporate bonds have plunged this year as interest rates have risen. Yet, high-yield (or "junk") corporate bonds have been relatively stable. They fell less during February's volatility panic and have been range-bound since.

In short, while folks having been getting worried about interest-rate risk, they simply haven't been concerned about credit risk. But that could now be changing.

The following chart compares investment-grade corporate debt – as tracked by the iShares iBoxx Investment-Grade Corporate Bond Fund (LQD) – and high-yield corporate debt, as tracked by the iShares iBoxx High-Yield Corporate Bond Fund (HYG). As you can see, high-yield debt is now breaking down, too. It has turned sharply lower over the past several days, and just closed at a new yearly low today...

It may not begin tomorrow, but make no mistake...

The next crisis is approaching. But as we've told Digest readers from the beginning, this crisis doesn't have to be bad news for you.

It will also create a once-in-a-decade opportunity to make huge triple-digit returns in the typically "boring" bond market, all while taking far less risk than buying individual stocks. But only if you're prepared... and only if you know what to look for.

Of course, this is exactly why we launched our Stansberry's Credit Opportunities advisory... to give individual investors like you access to the same little-known opportunities the world's best investors have been using to grow their wealth for decades. And there has never been a better time to come aboard. Click here to learn more.

New 52-week highs (as of 6/29/18): none.

A busy weekend in the mailbag: More on America's "savings crisis"... several folks weigh in on Porter's latest Friday Digest... and a reader is confused about the recent Toys "R" Us bankruptcy. As always, send your questions, comments, and criticisms to feedback@stansberryresearch.com.

"Dear Stansberry, I just started reading Porter's new [report] 'The Battle for America.' I'm sorry to say his description of the millennial mindset fits someone in my family very well. Rather than work his way through college he chose to borrow more than he could re-pay. Now of course he is all for the ideas of; forgiving student debt, medicare for all and universal basic income.

"And since there are now more millennials than baby-boomers I am worried that Porter may be right and a Debt Jubilee with the resulting chaos is becoming more and more likely. So I'm thankful for the [report] and any other suggestions to navigate this looming crisis." – Paid-up subscriber Brian E.

"The trouble with people like Brian O. is that they think the 'pie' is fixed and if my slice of the pie gets bigger it must mean that someone else saw theirs get smaller. It is sad so many people think this way. Thank you all at Stansberry Research for the 'learning' you make available to us subscribers." – Paid-up subscriber D.L.

"Here's my response to Brian O. In most cases the difference in outcomes between wealth and poverty can be attributed to the choices made during years of struggle to get ahead. Poor choices along the way by you or others is to blame, not our freedom based economic system that permits each of us to reach comfortable outcomes. Our nation offers the most opportunity to growth wealth of any in the world.

"My congratulations go to Charlene P. and others that have succeeded by combining self discipline, moderation and long term planning to enrich their lives. Success starts by a careful choice of who you marry and commit to stay married. Carefully pick the right minded person. Develop the habit of spending less than you earn and consistently invest the difference. Limit spending mostly to needs, not wants and find great joy in the simple things in life that cost nothing. These include lasting friendships, love of family and modest living. Reach out and help others in need when possible. I'm 82, been married to my loving wife for 58 years and have more than enough retirement savings to enjoy vacations, support church and charities and will enjoy life to its end. I ask for nothing more.

"My condolences to your friends that lost their home to fire. Unfortunately, there is no excuse for it not having been insured, not for one moment unless the cause of the fire permitted the insurance company to cancel. Nonpayment of the premium is not an acceptable excuse." – Paid-up Stansberry Alliance member Wayne S.

"Porter, first let me tell you that I don't always agree with your views, but your latest thoughts on why we should stop buying stocks got my attention and I must say makes a lot of sense. Relatively new to the investing world after nearly 37 years in the Canadian military, I have spent considerable time and effort since retiring nearly five years ago to learn all about investing, stumbling on your service about a year ago. I read everything that I receive from Stansberry Research and listen to your weekly podcasts. Despite all of your recommendations as well as those of Steve Sjuggerud, and despite an expensive subscription to a reputable and award-winning stock analysis and portfolio management system, I still find it difficult to make a healthy return by just buying stocks. I must admit that not following proven exit strategies and letting my emotions get the best of me might have hurt my performance (i.e. selling too quickly) but I suspect most individual investors fit this mold. Also, what made matters worse was that several of my blue chip stocks fell hard and as you know it's hard to recover from 35% overnight drops, even though each problematic child accounted for about 5% of the portfolio. That's what could and happens when you buy stocks.

"So all that to say that if one really stops to think about buying stocks, you really only have a 50/50 chance of being right as stocks will either go up or down. We do everything to get an edge by studying companies fundamentals, use technical indicators, follow market trends, listen to experts, etc. and even then, the best stock pickers get it right 65 to 70% of the time, and not on a consistent basis. One often quoted strategy is to let your winners runs at least 3 times the amount that you cut your losers so that a less than 50% individual stock win rate will produce a positive portfolio return. This is just another example that shows how difficult it is to pick stocks.

"One alternative to stocks that you did not suggest, probably because you were constructing a 'dumb' portfolio, and one which could be a lot safer if used correctly are stock options. Dr Eifrig would certainly agree that income-producing options have a higher winning percentage rate as you actually choose the probability of getting it right before entering the trade. Also, you can have less portfolio drawdown, what you call volatility, as you know/control the maximum loss even before getting into the trade.

"It might be serendipity at work but it is interesting how I've essentially just decided that buying stocks alone is not the way to go. I'll be heading down the option path, generating income knowing my probability of a winning trade and maximum risk all before making the trade. Given your latest insights, I will certainly investigate and consider commodities and/or gold to round out my portfolio." – Paid-up subscriber Larry C.

"Porter, you're brilliant. I love your work. I'm glad you mentioned the 'primary trend' for interest rates when it comes to investing in bonds. For 30 years, interest rates have been moving down causing bond prices to rise. The trend I think is now for interest rates to rise for the foreseeable future putting a drag on bond prices for decades. I think your [Stansberry's] Credit Opportunities is the place to be for bond investing in this environment.

"I've learned much from you, but I think investing in capital efficient businesses at reasonable (cheap) prices while reinvesting dividends, non-investment grade debt selling at irrationally discounted prices, gold, and real estate when on sale is the best way to grow wealth over time. Thank you for all you do. I'm still trying to be a saver and learner, but hope to one day soon begin to take action on your recommendations." – Paid-up subscriber Andy W.

"I think any investor with an open mind will be interested in your conclusions. The 'traditional' 60-40 allocation to stocks and bonds, as near as I can tell, did not contemplate the arrival of interest rates at the zero bound and that fact alone demonstrates why portfolios need to be re-balanced over time. It took 5,000 years of financial history for negative interest to appear but I suggest to my children that they re-balance at least every century. In general, though, I have long preferred bonds as my primary investment vehicle provided they provided a decent coupon and were reasonably supported by covenants. I suspect that the next turn of the credit cycle will produce many bankruptcies in which bondholders are as thoroughly wiped out as holders of equity so between zero-bound coupons and covenant-lite contracts, I have become extremely selective in what bonds I buy and your Credit Opportunities service has been immensely useful. In fact, my first Credit Opportunities buy was the NRP bond that did ridiculously well. I just recently closed another bond position when it went above par and I believe my return was in excess of 35%. Clearly it exceeds my threshold requirement of a 20% return by a lot.

"Over the past two years, I have moved an increasing portion of my investible assets out of stocks and into bonds (largely using the work of your Credit Opportunities service) and commodities. You made a compelling case for the bonds and James Cordier made a compelling case for commodities (in general) as an asset class not correlated to either stocks or bonds, although I have long had cyclical positions in certain resource commodities such as uranium. I had always kept Rick Rule's observation in mind – something like 'In the resource space, you're either a contrarian or a victim.' In the resource space, I let the current stage of the boom/bust cycle determine when to enter and when to exit and I spend a lot of time with no active positions. Right now, silver and uranium look promising and I do follow the resource-related information I find in many of the Stansberry publications and services.

"For the past two years, I have allocated about 25% of my portfolio to non-resource commodities trades, generally through futures options, and have been able to keep returns in the 20% range but I had been looking for a different approach and what should arrive in my In Box but your new True Wealth Opportunities: Commodities. This is one of the few instances in which I have been slightly ahead of a Stansberry product release but what I can say is that what Stansberry Research does better than anyone else is maintaining a range of financial information products that is unsurpassed in breadth.

"My plans going forward are to allocate funds across stocks (using various Stansberry products including Extreme Value as well as [Stansberry's] Big Trade put positions), bonds (Credit Opportunities) and commodities (True Wealth: Commodities) and from those I should have enough return to fund my lifestyle and keep growing the nest egg. Of course, I do have to have a small speculative play fund and in that realm, I often end up doing [Stansberry] Alpha trades with spectacular returns (such as the FFIV alpha trade). Sometimes I develop a wild hair and do my own Alpha trade such as the one I now have open on AAOI that has returned about 100% in a couple weeks after entering at a net credit about 28% of the margin required. Weirdly enough, some learning does appear to have its origins in teaching...

"And I do, of course, keep track of all my equity and options positions in TradeStops. Probably more importantly, I don't fear the inevitable downturn in the market because of the range of tools and information available to me (as evidenced by the current returns on the FTR and CAH Big Trade positions).

"I do keep some chaos hedges in the form of physical precious metals and cryptocurrencies but those are my only holdings that are truly buy and hold forever. Everything else is subject to change as the environment changes and Stansberry always gives me a superbly broad menu of reliable information in nearly all realms of investment. So... thank you for that!" – Paid-up subscriber Paul W.

"Hi Guys, you talk about [Toys "R" Us] as having too much debt to manage the repayment as if this entity went out and mindlessly incurred this debt. And not the fact that some greedy few individuals intentionally acquire the company through a leveraged buyout, took on enormous debt, then stripped and sold off parts of the company, put the profits in their pockets and left the company to pay off their debt.

"Then poorly guiding the company to its death, pun intended, failing to appreciate the changing economy and adjust accordingly, let it die.

"Then say to the employees, sorry we just could not make it work so we will just close the doors. Go home and find another job.

"This is criminal and the money stolen at the start should be seized and ameliorate the situation. Similar to a Ponzi scheme when the time for redress comes, the funds donated to even charitable organizations are returned to make restitution, so should the funds stolen be the leverage buyout artist." – Paid-up subscriber Whittaker B.

Porter comment: Whittaker, what you're saying ignores the fact that the equity owners of the business lost hundreds of millions of dollars – far more than they were able to strip out of the company. Nobody does that on purpose.

Regards,

Justin Brill
Baltimore, Maryland
July 2, 2018