'A collapse is coming'...

'A collapse is coming'... The three things that happen before a correction... Two signs this bull market isn't healthy... Volatility soars... Why Porter says today's trends aren't sustainable... And his bearish forecast...
 

 "Make no mistake, a collapse is coming... The warning signs are starting to flash. And it will end badly."

 

Jeff Clark sounded the alarm in today's Growth Stock Wire. He has been warning readers the market is setting up for a big correction.

 

No market goes straight up forever... And we're just 10 days away from three full years without a 10%-plus correction in stocks.

 

 Jeff pointed to three things that happen before a collapse...

 

First, interest rates spike. We're already seeing increasing Treasury yields – from a low of 2.35% three weeks ago to 2.52% today. As he wrote...

 

"For example, the 10-year yield was just 4.5% in January 1999. One year later, it was 6.75% – a spike of 50%. The dot-com bubble popped two months later. In 2007, rates bottomed in March at 4.5%. By July, they had risen to 5.5% – a 22% increase. The stock market peaked in September."

 

 Second, we see margin debt (money investors borrow to buy stocks) soar... Margin debt hit a record $464 billion in June.

 

So the first two indicators are in place... But we're still waiting on the third – the S&P 500 dropping below its 20-month moving average.

 

 However, this week's market action shows we may not have to wait long...

 

The S&P 500 has traded down three of four days this week, falling a total of nearly 2%.

 

As Jeff explains, we aren't there yet... But it's time to start preparing for a selloff.

 

And in today's Digest, we'll share some other bearish indicators in the market today...

 

 Federal Reserve Bank of Dallas President Richard Fisher said we may see interest-rate hikes sooner than expected. As Fisher said in a conference in Rome today...

 

It's assumed in the marketplace that we'll start our liftoff in raising interest rates sometime between the spring and the summer. I won't say what we're saying internally, that would not be appropriate, but maybe sooner rather than later.

 

 As Steve has pointed out, higher interest rates aren't necessarily bad for stock prices... But a sudden jump in rates could spook an already-jittery market and cause a quick selloff.

 

 Extreme Value research analyst Mike Barrett passed along two other bearish indicators...

 

Between 2009 and 2013, the S&P MidCap 400 – an index of mid-sized companies – rose 158%. The Russell 2000 – an index of small-cap stocks – rose 124%. Finally, the S&P 500 – an index of large-cap, blue-chip stocks – rose 119%.   But while small- and mid-cap stocks led the market over that time, they are now lagging. Since the beginning of this year, the Russell 2000 has lagged the S&P 500 by the widest margin in three years. The S&P MidCap 400 is also lagging by the widest margin in two years.   As technical analyst John Murphy reports, "What that means is that the stock market rally is getting narrower. In other words, fewer stocks are participating in the uptrend. That's normally an early warning of a possible correction."   Meanwhile, large-cap stock indexes like the S&P 500 and Dow Jones Industrial Average have hit new highs this month. But large-cap indexes are usually the last ones to roll over. Per Murphy, "We may be getting close to that possibility – especially in the middle of the seasonally dangerous September-October period. The situation will get a lot more serious if and when the Russell 2000 falls below chart support along its May/August lows."

 

Mike notes an additional warning: the percentage of New York Stock Exchange-listed stocks trading above their 50-day moving average (DMA)...

 

During a healthy bull market, as the NYSE Composite Index climbs to new highs, it's normal to see more and more stocks that comprise the index trading above their 50-DMA. This past summer, about 80% of NYSE-listed stocks were trading above their 50-DMA.   But when the index hit a new high earlier this month, more than half its stocks were trading below their 50-DMA. Currently, almost half of NYSE composite stocks are also trading below their 200-DMA.   These are not signs of a healthy bull market. Market technicians are now carefully watching the Russell 2000. If the index moves below its August lows, this could pose a major threat to the entire market.

 

 Plus, the market's "fear gauge" – the Volatility Index – soared nearly 25% today to more than 16. We're up almost 60% from the lows... but still far from the financial crisis highs of 80.

 

With the market looking tumultuous today, I asked Porter for his thoughts. Regular Digest readers know Porter has been bearish for years. He sees lots of unsustainable trends in the market today – particularly the low yields in the high-yield corporate bond and Treasury markets...

 

Very low interest rates have led investors to price stocks at nonsensical levels if interest rates were to normalize. You could picture this as a house of cards that's all resting on unsustainable interest rates... We have been told that manipulation of the bond market is going to end soon via tapering.   As interest rates normalize, I expect at the very least, stocks will correct. But as things in the stock market tend to not be very orderly, I wouldn't be surprised if stocks correct substantially.   The Fed has altered the financial markets in a way that has inflated the value of fixed income and has thereby inflated the value of stocks. And when that inflation ceases to exist, we'll see a much more normalized price for stocks and bonds.

 

 Porter says he wouldn't be surprised to see a worst-case scenario where the market falls in half...

 

A 50% correction in bonds and stocks wouldn't be unusual. Generally speaking, rising interest rates are a sign of greater economic activity, which could lead to higher earnings, which could propel share prices higher in the short term. But what is different about the situation today, as opposed to previous times, is that bond prices and stock valuations have been driven to levels that the economic fundamentals don't support. We know why that happened: the Fed printed $4 trillion and bought bonds. And we know that can't continue.   So again, as the Fed unwinds its quantitative easing, we should expect a correction in stocks. Investors should be skeptical about a $4 trillion departure from normalized economic fundamentals. Everyone should err on the side of caution. But instead, many investors have become euphoric. That's my biggest concern. When something that should inspire caution instead causes euphoria, it never ends well.

 

 As we noted in Tuesday's Digest, it's good to be nervous today.

 

The Fed's actions have made it impossible for investors to earn a decent return in savings or government bonds... And people are being forced into riskier assets. But the investing world is buying these overvalued assets willingly... rabidly, even.

 

Remember the famous line from Warren Buffett, the world's greatest investor: "Be fearful when others are greedy and greedy when others are fearful." There's no doubt greed has overtaken the market today... Just look at the low yields on high-yield ("junk") bonds – the riskiest corporate credits – or the fervor surrounding Alibaba's initial public offering.

 

We're not saying the market will correct tomorrow, but it is coming eventually... And you need to prepare.

 

 

 New 52-week highs (as of 9/24/14): CF Industries (CF), WisdomTree Japan Hedged Equity Fund (DXJ), ProShares UltraShort Euro Fund (EUO), Johnson & Johnson (JNJ), Altria (MO), ProShares Ultra Health Care Fund (RXL), and Skyworks Solutions (SWKS).

 

 In today's mailbag, Porter responds to one subscriber's prediction about a collapse in coal prices. Send your e-mails to feedback@stansberryresearch.com.

 

 "I really appreciated Porter's comments in the Ron Paul interview podcast program about the underclass in the US. I agree that this is not racial. It is a big and growing problem that – like so many other problems we currently observe – threatens to bankrupt our nation. There is no real incentive to try to break out of poverty when you can do so well just sitting around and collecting from the myriad government programs available. It takes a clearly middle class income to be better off than just letting life happen. Why work hard, go to night school, work your way up when you can approach that middle class lifestyle without lifting a finger?

 

"While there are cultural issues contributing to this, I say the fundamental problem is the progressive (I say regressive) nanny state government policies that restrain those who could otherwise work to get ahead. If these unfortunate victims of government disincentive were to work hard and climb the income ladder they would simultaneously help themselves and strengthen our country economically instead of weakening it. Trouble is: there is no great incentive to do so. I know a person who is on disability social security and who cannot take on a job she could actually do because she would lose more than she'd gain from the job income. I had a person who had a lung transplant say that after recovering from the surgery he got a job, but had to quit because the government cut off funding for the anti-rejection drugs which he could not otherwise afford. As a taxpaying citizen, I'd much prefer to pay for his pharmaceuticals while he works than while he sits idle. Keep telling the truth and maybe someone will actually get the message!" – Paid-up subscriber Gary

 

 "Porter, your analysis and letters are great. While your emotions are driven by logic... i.e. your logical 'rant' against the management of Devon Energy... your logic never gets overtaken by emotion. That means I get analysis I can count on and I appreciate that. After reading the piece on Devon Energy it struck me how undervalued natural gas may be, especially considering additional demand including emerging market demand, electric energy generation, transportation including train, automobile and truck usage.

 

"However, after reviewing the EIA website and looking at the growth of shale gas production from less than 1b billion cubic feet per day in 2000 to approximately 37 billion cubic feet in 2014, how can one measure demand to supply to logically deduce natural gas relative price strength in the future, especially with increasing oil supplies from the same shale areas, which should drive oil prices lower as well?

 

"In short: Is demand growing at the rate of production or higher? Or is there some point in the future, based on prices, that we will see a serious downturn in production based on the 'over' supply and see a significant downturn in supply? Or is there some fault in my reasoning?

 

"I really don't know how the catalyst would work to drive natural gas prices significantly up again and wanted to know your thoughts? Thank you for your frank, sincere newsletter." – Paid-up subscriber Kevin

 

Porter comment: Kevin, I believe you may be conflating a few key statistics in the formulation of your question.

 

What matters for the price of natural gas going forward isn't the total amount of shale gas production (which is large and growing), but the total production from all types of wells. Here are a few figures to consider on that basis. Domestic production of natural gas last peaked in 1973 at nearly 23 trillion cubic feet annually. In the 41 years since then, U.S. production has been remarkably stable, at around 20 trillion cubic feet annually, with a low in 1986 of around 16 trillion and a more recent high in 2001 of about 21 trillion cubic feet.

 

You might reasonably wonder how it was possible that natural gas production didn't grow in the U.S. for more than 40 years. The answer is simple: prices didn't increase much in real terms (adjusted for inflation). In real terms, the price of natural gas in the U.S. in the mid-1970s was around $4 per thousand cubic feet (mcf). That average price didn't change much until the mid-2000s. Yes, there were short-term price spikes – but the average price in real terms for that 40-year period was about $5 per mcf. As a result, there wasn't much profit in drilling for natural gas. Rather than produce more supplies domestically, North American producers began to import a lot of cheap gas from Canada. This happened because of economics and regulations (cheaper gas and fewer government hassles), not because of Peak Oil.

 

The result: By 2006, the U.S. was a net importer of natural gas by about 4 trillion cubic feet per year. Companies like Cheniere Energy (LNG) began building huge liquefied natural gas import facilities, based on the widespread (but utterly mistaken) belief that U.S. natural gas production was in a state of permanent decline. The real cause, however, was economics. As soon as natural gas prices increased enough to spur the investment necessary for drilling and production facilities to be built, production began to soar.

 

As late as 1999, there were only about 600 operating natural gas drilling rigs in the U.S. By 2008, however, there were more than 1,600. Today, domestic production has grown by about 25% – to more than 25 trillion annually. Yes, shale gas production has grown tremendously, but most conventional production has slowed. So overall production has grown (though not as much as you might think). Meanwhile, the new domestic production has created huge new demand for natural gas in the U.S. (a phenomenon known as "Say's law"). Domestic consumption of natural gas is now more than 26 trillion cubic feet annually. The difference between supply and demand is still met by Canadian supplies.

 

The big change in the dynamic of the natural gas market isn't shale production. It is the growing abundance of "associated" gas – that is, natural gas produced as a byproduct of oil production (not as a result of gas-specific drilling). Today, almost no dry-gas drilling is taking place in the U.S. Yet despite the steep drop in the natural gas rig count since 2009... natural gas supplies continue to grow. This suggests that natural gas prices are likely to remain low for as long as oil prices remain high.

 

But... what will happen to natural gas prices if the breakneck pace of shale-oil drilling were to slow?

 

Sooner or later – and it may be happening right now – growing domestic supplies of oil will begin to lead oil prices lower. That would reduce drilling, which in turn would reduce the supplies of associated gas. That will mean suddenly higher prices of natural gas at the exact moment revenues from oil production are falling.

 

That's my main concern with Devon's huge ($10 billion-plus) and ongoing investments into oil sands. Devon is investing in a business – steam-assisted gravity damage (SAGD) oil-sands production – that uses cheap natural gas to produce fairly expensive oil. These investments are massive and will require a long time to produce a profit large enough to repay the initial capital investment.

 

If oil prices fall while gas prices rise, Devon could see large losses on this investment. Historically, it's not unusual to see energy cost more in the form of natural gas than it does in oil. Once you realize that, you begin to see the real risks to this project. I don't think Devon's management team understands these risks...

 

Regards,

 

Sean Goldsmith

Baltimore, Maryland

September 25, 2014

 

A peek behind the curtains of Extreme Value...

 

When it comes to determining stock valuations, Extreme Value editor Dan Ferris is one of the best in the business.

 

In today's Digest Premium, he explains his investment approach... and offers some advice on how to value a business...

 

To subscribe to Digest Premium and receive a free hardback copy of Jim Rogers' latest book, click here.

A peek behind the curtains of Extreme Value...
 

Editor's note: When it comes to determining stock valuations, Extreme Value editor Dan Ferris is one of the best in the business. In today's Digest Premium, he explains his investment approach... and offers some advice on how to value a business...

 

 

 Extreme Value uses a bottom-up approach, which helps us learn enough about a business to see if we're interested in it. We learn enough about the management to know if we think it will do a good job taking care of shareholders' money. And we figure out if it's selling for a cheap enough price in the market to make a good investment.

 

The greatest company in the world can be a bad investment if you don't buy it cheap enough. People who bought the greatest companies in the world at the top of the market in 2000 know that. They have just barely broken even again in the past couple years.

 

 Once we put the business, management, price, and everything else together in the valuation, we can make a decision.

 

One thing we look for in valuation is a metric called "free cash flow." You can get this number by subtracting capital expenditures from the company's operating cash flow. Free cash flow is a simple and effective way to determine how much cash a company generates after maintaining and growing its business.

 

 A lot of people look for a formula. But I (Dan Ferris) don't think there's a formula. You have to know the value of a business, and you have to be disciplined enough to be able to look at a company and say, "You know, maybe I just don't understand this company well enough." And then you move onto another one.

 

If you take this approach, you're just thumbing through the market one stock at a time to see if you would want to own something, even if it might be too expensive today. If it's too expensive, you put it on a shelf and hopefully you get to buy it one day.

 

 Different businesses are valued in different ways. A company that manages mutual funds and client assets is essentially valued on a percentage of its assets under management. If another company wants to buy it, that's how it would think about the value. That's one way people think about it, anyway. With banks, you want to look at their assets and their tangible book value.

 

If you're looking at an oil and gas company, the most important thing is reserves. Where are they? How much are they? Who operates in that area? How have they done in the past? Has this company operated well in that area in the past? You want to know what the value of those reserves is, plus the answers to all that other stuff. Then you want to learn about its management team.

 

Even if there was a formula, it would be different for every industry. It would also be adjusted for every company, because every company has something a little different under the hood when you start looking at it closely.

 

In Extreme Value, we also devote a good amount of time to helping our subscribers learn how to value stocks. We believe that's much more valuable than simply providing them with a brand-new stock recommendation month after month. We're doing our readers a disservice if we don't teach them something along the way.

 

– Dan Ferris

 

 

Editor's note: Dan's track record speaks for itself. Of the 29 stocks in the Extreme Value portfolio, 27 are showing a profit. He has eight triple-digit winners and an average gain of 77% across his current open portfolio. In tomorrow's Digest Premium, he will discuss how he discovered what he calls "the best resource opportunity of my career"...

A peek behind the curtains of Extreme Value...

 

When it comes to determining stock valuations, Extreme Value editor Dan Ferris is one of the best in the business.

 

In today's Digest Premium, he explains his investment approach... and offers some advice on how to value a business...

 

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