Another Sign of Trouble in the Credit Markets
Another sign of trouble in the credit markets... 'Safe' bonds are rolling over, too... What our proprietary Complacency Indicator is saying now... GE is broken...
In yesterday's Digest, we noted new signs of trouble in the corporate credit markets...
Specifically, we pointed to two troubling developments in high-yield (or "junk") bonds. As we wrote...
For the first time in nearly three years, we're now seeing the first real signs of stress in the corporate credit markets.
First, as you can see, the spread between junk bonds and U.S. Treasury bonds has surged higher. It has risen from below 2.1% in September to more than 2.8% today, officially creating a "higher high"...
More concerning, after showing relative strength in October, junk-bond prices are suddenly plunging. Not only have they turned negative for the year, they've just created a "lower low" below their November 2016 bottom...
But junk bonds aren't alone...
Investment-grade bonds have been weakening, too. And as you can see in the following chart, these more highly rated bonds are now in a downtrend as well...
Typically, this wouldn't be particularly concerning... Remember, all bond prices move inversely to interest rates. This is what's known as interest-rate risk. Given that long-term interest rates have been moving higher recently, it's not unexpected to see even investment-grade bonds move lower, too.
Yet, traditionally, investment-grade bonds have carried very little credit risk. That is, the likelihood that one of these highly rated companies would default was slim. So as long as investors held these bonds to maturity, they would ultimately be paid back in full – meaning they could more or less ignore the prices of these bonds in the meantime.
However, longtime Digest readers know that isn't necessarily the case today...
That's because a huge amount of this "safe" debt is actually anything but. As Porter explained in the September 21 Digest...
A record amount of investment-grade debt is set to be downgraded. I've long warned that huge growth in BBB-rated corporate bonds (one notch above "junk" bonds) would eventually cause a huge problem for investors... But the latest numbers are simply astounding... unbelievable... unprecedented.
Since the European Central Bank began buying huge amounts of corporate bonds just two years ago, the number of BBB-rated bonds in the core bond indexes has more than doubled all other rated bonds combined. These indexes are built to mirror the market, meaning the character of the market has experienced a profound change, with a huge skew in issuance toward the lowest-quality bonds.
In other words, "investment-grade" just doesn't mean what it used to. More from that Digest...
Think back to the last big financial boom... Back then, the primary driver of credit excess was Wall Street's seemingly magical ability to transfer "toxic waste" – aka adjustable-rate subprime mortgages – into AAA-rated bonds.
Well, the big trick in this credit bubble is the central banks' intervention into the corporate-bond market, which has transformed corporate junk bonds into investment-grade bond indexes that essentially trade at par with sovereign bonds.
We've long warned that it was simply a matter of time before a huge amount of this debt was downgraded to junk, hastening the end of credit cycle. So the new downtrend in investment-grade bonds is concerning.
Again, as we noted yesterday, it's too early to panic...
These signals suggest the risk of a bear market is rising. But they don't guarantee we'll get one.
As longtime readers will recall, we saw significant warning signs in the credit markets in late 2015 and early 2016, and yet the bull market continued. That could be the case this time as well.
Still, we continue to urge caution today...
Earlier this month, we noted that our proprietary Complacency Indicator had fallen during October's broad market correction. In other words, despite a significant decline in stocks, investors actually became more complacent as they fell.
This is unusual. Typically, we see investors become more fearful as stocks decline. At significant market bottoms – think 2009, 2011, or 2016, for example – they often become downright terrified. So our indicator suggested the correction could have further to run.
Of course, we now know that was exactly right. After a strong rebound to begin the month, stocks resumed their downtrend. Both the Dow and the S&P 500 have given up most of their recent gains, while the tech-heavy Nasdaq has fallen to new lows.
Surely, investors must be getting a little worried now, right?
Unfortunately, that doesn't appear to be the case.
According to the Stansberry's Investment Advisory team, the Complacency Indicator sits at just 11.5 today. This is slightly higher than October's reading of 8, but still well below the 30 level that suggests caution is warranted. Again, despite the latest pullback, investors remain extremely complacent today.
As Porter's team noted last time, this doesn't mean the market will necessarily continue its decline. But it's a good reason to remain cautious and "hedged."
Speaking of risky investment-grade bonds...
Regular readers should know the debt of former iconic industrial giant General Electric (GE) ranks near the top of the list. Already, the company is caught in a "death spiral." At today's interest rates, it's barely earning enough money to service its massive debt loads.
If the company loses its investment-grade rating – and again, we believe it's simply a matter of time – these problems would become critical in a hurry.
But maybe you're still not convinced about the risks to GE investors...
Maybe, despite our repeated warnings, you're still holding on to shares, hoping they'll "come back." Or maybe you're considering trying to "catch a falling knife" and betting on a big rebound in prices.
If so, we'd encourage you to take look at the following chart. It shows GE's share price going back to the 1920s...
As you can see, it has now broken its 90-year uptrend with authority. This didn't happen even during the worst of the 2008-2009 financial crisis, when GE was teetering on the edge of bankruptcy.
Sure, we could see bounces along the way, but the market is sending us a serious warning. Significantly lower prices – even a total wipeout of shareholder equity – are possible. Ignore this at your own risk.
New 52-week highs (as of 11/20/18): Essex Property Trust (ESS).
The Stansberry Research offices are closed tomorrow and Friday for Thanksgiving. We hope you enjoy the holiday. We'll pick back up with our regular Digest fare on Monday. Until then, feel free to send us a note at feedback@stansberryresearch.com.
"[I'm an] Alliance member. No matter my percentage of stocks, protecting those positions is important to me. Would buying the puts listed in Stansberry's Big Trade be consistent with your generalized strategy to hedge?" – Paid-up Stansberry Alliance member Mark T.
Brill comment: Absolutely, Mark. The troubled, overly indebted firms that make up the Stansberry's Big Trade "Dirty Thirty" are excellent hedges. We expect many of these stocks to go to zero in the next bear market... Yet they're likely to underperform even if the bull market continues.
Regards,
Justin Brill
Baltimore, Maryland
November 21, 2018