The Unsinkable, Overextended Ship

Nobody keeps buying and buying forever... How to choose your capital allocation... The unsinkable, overextended ship... Historical patterns in margin... U.S. households are back in debt... The market's coiled spring... Get your finances in order...

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I'll sing this song until the inevitable reckoning comes...

Lower your expectations for stock market returns, especially if you're contributing to a 401(k) or other account that's investing in the S&P 500 Index, Nasdaq Composite Index, or something close to either one.

The market is very expensive compared to history. I've shown you that in a number of ways. And here's the latest...

Analyst Charlie Bilello posted Wednesday on the social platform X, where he pointed out that the S&P 500 is now trading at 25.8 times peak earnings. That's the highest valuation since 2000 – the year the dot-com bubble peaked.

I've been telling you stocks were anywhere between expensive and egregiously overvalued for most of the past few years. During that time, we had an epic Melt Up that ended with a 25% bear market in the S&P 500 and a 36% drawdown in the Nasdaq.

The bear market was then followed by... another epic Melt Up. Since the market bottomed about two years ago, the S&P 500 is up 60%. And the Nasdaq is up 77% off its December 2022 trough.

Is this what we can expect from the stock market from now on...? Epic rallies into hyper-expensive valuations, followed by bear markets during which stocks never become attractively valued?

To be fair, the S&P 500 is up more than 270% since the dot-com peak and more than 630% from its dot-com bottom. You could have kept buying and buying endlessly and you'd have made plenty of money.

Problem is... nobody keeps buying and buying forever...

They buy more and more as the market goes higher and higher. Their conviction is highest right when the risk is greatest. And they buy nothing when the market bottoms out.

A lot of what I publish in the Digest, Extreme Value, and The Ferris Report is geared toward avoiding those tragic outcomes. I seriously doubt anybody can time the stock market consistently, especially at the top... but I also doubt you'll make serious money if you remain oblivious to the fact that this is the riskiest moment of your investing career, as I said last week.

As for what to do about it... in his latest memo, investor/author Howard Marks of Oaktree Capital Management laid out the fundamental decision for deciding how to allocate your money...

In my opinion, one decision matters more than – and should set the basis for – all the other decisions in the portfolio management process. It's the selection of a targeted "risk posture," or the desired balance between aggressiveness and defensiveness. The essential decision in investing is how much emphasis one should put on preserving capital and how much on growing it. These two things are mostly mutually exclusive:

• Insistence on preserving capital – or, secondarily, on limiting the portfolio's volatility – calls for an emphasis on defense, which precludes pursuing maximum growth.

• Correspondingly, a decision to strive to maximize growth requires an emphasis on offense, meaning preservation of capital and steadiness must be sacrificed to some degree.

The first question you should ask when allocating every dollar you invest is whether your goal is capital preservation or capital appreciation. Once you decide what mix of those two you want, Marks divides the two priorities between the two asset classes he considers most important...

Marks says ownership assets (like stocks) are best for offense and debt assets (like bonds) are best for defense...

You must then decide for yourself what mix of the two priorities (and their corresponding assets) you want by consciously targeting "the absolute level of risk," as Marks puts it.

Say you want an investment that returns 7% to 10% a year with minimal volatility and you're willing to forgo further upside potential... Marks suggests you do more research into bonds and start putting more money there.

Marks points out that, historically, that's also about what you could expect to make in equities over the long term. Given the current equity-like return available, the added protection of investing in bonds and loans ought to be enticing to all investors who understand his point about risk and reward.

Sure, his firm, Oaktree Capital, specializes in debt investing... with roughly 78% of the firm's client assets in loans, bonds, and other credit instruments. So he's talking his book. But he's a highly credible voice, and he makes a reasonable point in a balanced way. I tend to think of him as the Warren Buffett of debt investing.

I've recommended bond funds in The Ferris Report, and my colleague Mike DiBiase focuses solely on bonds in his Stansberry's Credit Opportunities newsletter.

It's a bit ironic that, as Marks describes it, debt is the less-volatile, safer alternative...

It's ironic because leverage – the use of debt to increase portfolio returns – is many investors' undoing. During bubbles, leverage tends to build up and then get wiped out when the market finally collapses under its own weight. Generally speaking, owning debt instruments puts you on the side that gets paid even when equity holders get wiped out.

All this talk of leverage comes on the heels of new information regarding this past summer's tragic death of Mike Lynch and six others, which I told you about in the August 23 Digest.

Lynch was a tech entrepreneur and billionaire celebrating a legal victory with his wife, daughter, and several friends by cruising around the Mediterranean on his 184-foot superyacht, Bayesian.

The Bayesian sank in a storm off the coast of Sicily on August 19, killing Lynch, his daughter, and five others. According to witnesses, the yacht disappeared from view surprisingly quickly.

Folks were shocked that it sank at all.

Giovanni Costantino, chief executive of the Italian Sea Group – which owns the Bayesian's builder, Perini Navi – told the New York Times recently...

The ship was an unsinkable ship. I say it, I repeat it.

It sank anyway...

The main reason, according to engineers and other experts the Times spoke with, is its unusually tall single mast. That type of boat usually has two shorter masts, but the boat's original buyer (not Lynch) insisted on the single tall mast.

At an astonishing 237 feet, it was one of the tallest masts in the world, with folks stopping to stare at it when it came into port. A passenger who'd ridden on the boat before its fateful cruise recalled that its ultrasmooth ride under sail made it feel like the Bayesian was gliding.

The large, top-heavy mast also made it more likely for the ship to capsize. Other risk factors included large glass doors, a sunken forward deck, and air vents too close to the water line. The ship's retractable keel also was not fully extended when it sank.

The same storm hit other similar boats moored near the Bayesian, but they didn't sink. Despite its other problems, it might not have tipped over and sunk if not for that gigantic mast. In other words, leverage sank the Bayesian the same way it sinks many investors who've used margin during the past few bull markets.

Without that giant, heavy lever sticking out of it, Lynch and his family and friends might still be out there cruising the world right now.

Likewise, without the use of portfolio leverage, many investors who left the market during crises might still be in it... compounding at relatively high rates and not worrying much about their portfolios from year to year.

The amount of margin is getting back up to levels not seen since the fall of 2021 – right before the 2022 bear market...

Data from the Financial Industry Regulatory Authority ("FINRA") shows that folks have currently borrowed $830 billion to buy securities. As the chart shows, that's not far below the record for margin of more than $900 billion, set in late 2021.

On the other hand... some folks will say the absolute level of margin doesn't mean much, that you have to measure it in relation to the whole market's value. That metric shows you whether folks are continuing to use margin at the same rate when stocks change price.

And indeed, if you run the numbers that way, you get quite a different picture...

Margin peaked at just shy of 2.5% of total market cap in September 2008 – the month Lehman Brothers went bankrupt – in the depths of the financial crisis. Terror swept through the markets and margin declined until December 2009, when it bottomed out and rose again, remaining consistently at or above 2% of total market cap until early 2019.

What I see here is the rising use of margin debt... with a potentially large runway to increase that usage as the market (potentially) melts up in the coming months.

And there's another way to look at where we are right now, which indicates folks are more comfortable than they've been in years with having plenty of debt...

That same period of deleveraging in the stock market corresponds with a wider trend in the economy...

The folks at The Daily Shot published this chart recently, showing net household liabilities (liabilities minus cash and cash equivalents) as a percentage of disposable income...

You can see the liabilities peaking just before the financial crisis, same as in the margin/market cap charts. Then you can see it just about touching zero around 2021 – meaning zero net liabilities, a complete deleveraging of households.

Since then, liabilities have risen to around 10% of disposable income, inspiring The Daily Shot to caption the graph, "US household deleveraging has bottomed."

It remains to be seen if the bottom for household liabilities is in, but we know that Americans have spent the $2.1 trillion they saved during the pandemic. They'd already burned through that by May of this year.

It seems that, having finally burned up their excess cash, folks have started using more credit cards, home-equity lines, and other forms of consumer debt to keep spending. Total credit-card debt is more than $1.14 trillion now – the highest balance since the Federal Reserve began tracking it in 1999.

And we also know they've been using credit in the form of "buy now, pay later" programs, which let you quickly break up a purchase into a series of monthly payments. If you shop online, you've no doubt seen these options on your screen.

And folks aren't just using this credit for frivolous expenditures, either. Some 15 million Americans used these programs to buy groceries last year.

You see? Folks are borrowing more and more to buy stocks... and more and more just keep their household spending at the same level…

Sooner or later, these two trends of rising debt usage will overwhelm households...

Remember, the government can print money. Households have to earn it. As they borrow more in their brokerage accounts, their risk of loss rises. And as debt rises relative to disposable income, the likelihood of default goes up. Many households are just a layoff away from financial disaster.

All of it suggests to me that maybe we're about to see some fireworks in the stock market as folks recover from election uncertainty and start buying again... if they do start buying again.

As usual, I won't make any predictions. I need to know where the data says we are right now and think about what it's reasonable to expect to happen next.

I can't help mentioning that the rise in total margin aligns roughly with the period of the easiest monetary policy and the lowest interest rates in recorded history.

Then the amount of margin debt soared to an all-time high of more than $900 billion just as inflation was ticking up toward new 40-plus-year highs. And now, just as households are running out of dollars to spend, margin is sitting near its lowest levels since before the 2008 crisis.

Folks got used to the regime of easy money... which is just another way of saying they got comfortable with lots of inexpensive borrowing. The past two and a half years of higher inflation have only just begun to beat that old feeling of comfort out of them. I believe the beatings will intensify until folks start realizing they're too levered up, both in their household budgets and their brokerage accounts.

It all feels like a coiled spring, with stocks ready to bounce higher and deeper into mega-bubble heights than ever before, enticing even more borrowing... before plunging to lower bear market crisis depths than they have in decades.

A final note today...

Household liabilities were on my mind after talking with our friend Austin Root on the current episode of the Stansberry Investor Hour podcast...

Austin is the chief investment officer at Stansberry Asset Management ("SAM"). SAM is a U.S. Securities and Exchange Commission-registered investment adviser, completely separate from our Stansberry Research publishing business. But it uses our research, plus other sources, to help manage individual client portfolios. For more information on Stansberry Research's relationship with SAM, click here.

At SAM, Austin encourages his clients to get their financial houses in order. Only after they pay down their high-interest debt should they think about what to do in the stock market.

In other words, investing isn't just what you do in the stock market. It's what you do with all your money.

You should have a good positive net worth if you're going to put money into stocks. You don't want to be in a position of needing to liquidate a sound long-term investment because your income is being overwhelmed by too much high-cost debt.

Few of our guests delve into personal finance issues like that, and Investor Hour co-host Corey McLaughlin and I found it refreshing. You can watch our full interview with Austin here.

I've occasionally said that the fundamental skill beneath every type of investing is saving – setting aside capital for the future. In the end, being rich means having a big pile of wealth you didn't spend. Whether it's in cash, gold, stocks, bonds, real estate, or other assets is secondary to that fundamental truth.

As Austin spoke, I was reminded of the data on credit cards and net liabilities I shared above. The releveraging of households suggests they're headed in the wrong direction after heading in the right one for years.

Inflation will do that.

Four-decade-high inflation has left folks struggling to the point where their excess savings are gone, and they're using credit cards and "buy now, pay later" just to make ends meet. It's tragically ironic that the government's issuing of more than $800 billion in cash to Americans during the pandemic is one of the culprits contributing to the post-pandemic surge in inflation.

So keep your debts under control, including high-interest consumer debt and margin in your brokerage accounts.

There are times when you get away with that sort of behavior. But I don't believe this is one of them.

New 52-week highs (as of 10/31/24): AbbVie (ABBV), Sprouts Farmers Market (SFM), Summit Materials (SUM), Texas Pacific Land (TPL), and Twilio (TWLO).

In today's mailbag, a question about GDP data, stemming from our Wednesday edition... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Good morning Corey. The government likes to tout good GDP numbers, but I don't recall seeing both a gross GDP number and a GDP number net of inflation. If the economy 'grew' by 2.8%, but real inflation (not their cherry-picked numbers) was running at 1% (or higher) for the quarter, then we really can't say GDP expanded by 2.8% (with the implication it grew from increased productivity). Is there a thinktank that publishes real numbers that strip out increases solely from inflation so that we can measure the real productivity of the economy?" – Subscriber Scott P.

Corey McLaughlin comment: Scott, thanks for the question.

The short answer is the 2.8% third-quarter number you're referring to that we discussed the other day is "real" GDP growth, which does account for inflation... at least somewhat.

The government uses what it calls the GDP Price Deflator to adjust for inflation, and in this third-quarter GDP estimate, its inflation estimate was 1.8%. Without that consideration, nominal GDP growth was 4.7%, according to Uncle Sam.

Of course, these headline numbers that are quoted in the mainstream media don't tell the whole story, or even close to it...

First off, we're skeptical about whether the government's inflation adjustment is "real" enough.

Second, consumer spending, which makes up about two-thirds of economic activity in the U.S. and grew at a 3.7% pace, is an aggregate dollar measure... meaning it grows with higher prices. So GDP is essentially giving credit to inflation for "growth."

Beyond that, barely any of the reported GDP during the third quarter was from private investment (0.3%), and a lot was from government spending, including a roughly 15% annualized gain in national defense spending – even after adjusting for inflation.

Long story short... I agree that the headline numbers aren't what they are cracked up to be. If people are simply spending more dollars on the same goods and services that cost less before, and in large part because of government policies and spending, is that "real" production?

I don't think so. And it's one big reason why I expect to be hedging inflation forever.

Good investing,

Dan Ferris
Eagle Point, Oregon
November 1, 2024