Financial 'gravity' is returning to the market... Why we keep writing about oil... How to stay safe today... Why 'Doc' isn't worried...
"I believe that some combination of rising interest rates, rising defaults in the corporate bond market, and global currency/trade wars will likely cause the U.S. stock market to decline substantially.
"No, I don't know the exact timing of such a move. But I believe it will happen within the next few months. Downward reversion to the mean will play a role."
The Dow Jones Industrial Average has plunged more than 1,500 points since Porter wrote those words one month ago today. He followed them up with a detailed explanation a few weeks later in the August 14 Digest...
For many years, subscribers have asked us about the inflation/deflation debate. In our minds, there was never a debate. The greatest contribution the "Austrian" school of economics made to financial thought was the proper definition of inflation.
Most people, however, still do not understand that inflation isn't necessarily the increase of prices according to an index. Often, credit inflations do not cause rising prices at all... They frequently cause falling commodity prices. The proper definition of inflation is the creation of credit in excess of savings and foreign investment. And by that definition, the Federal Reserve has initiated one of the greatest inflations in history.
The Fed has provided $4 trillion in additional credit to the U.S. Treasury. Saving didn't create this credit. It was created out of thin air. That's a perfect example of inflation. For the last six years, this immense amount of credit has artificially reduced the cost of capital across our entire economy – lowering it to almost zero. It's as though the Fed suspended "gravity" in our economy. And not surprisingly, a boom erupted where this credit landed.
This cheap credit is responsible for the "Bernanke Asset Bubble" we've discussed many times. But it hit some areas of the economy particularly hard...
The two most popular beliefs in the credit markets back in 2009 guided where most of the credit went. Back then, even sophisticated people on Wall Street (including Warren Buffett and GMO Financial founder Jeremy Grantham) genuinely believed we were running out of oil.
The performance of car loans during the crisis had convinced lenders that consumers wouldn't default on car loans because they had to have the vehicles to get to work. (The line back then was that you couldn't drive your house to work, so you'll default on your mortgage, but not on your car loan.) A related trend was the government's efforts to essentially guarantee all student loans. Presto... the credit flowed there, too.
In the short term, these policies have stimulated our economy. Texas led employment growth following the last recession. Outside of employment related to oil investments, employment hasn't grown at all in the U.S.
Likewise, the two other booming areas of our economy have been auto sales (which neared an all-time high last year with 17 million new cars sold) and capital investment in higher education. Drive through any major university and you will see plenty of cranes. It's no surprise that the only forms of consumer credit that have grown since 2009 are student loans and car loans. Total outstanding car loans just passed $1 trillion for the first time ever.
While the result has been an economic boom, Porter says it's due to a "phony" signal. And it encouraged a lot of investing and borrowing that otherwise never would have happened without cheap credit.
Or as Porter put it, with financial "gravity" near zero (super-low capital costs), almost anything will "fly." But when gravity returns, these same "investments" will head back to earth in a hurry...
A lot of the money invested in the oil business, for example, has gone into projects (like the oil sands) that aren't economic and aren't likely to be in a lifetime. A lot of cars were built and sold to people who can't actually afford them. These people will eventually default. Sooner or later, soaring car loan defaults will drive down the prices of used cars, making it difficult to sell new ones at a profit.
That's the downside to a phony boom. Since these investments weren't financed with actual savings, there won't be enough demand to sustain the debts that have been created. You can think of savings and investment as a see-saw. Without roughly the same amounts on either side, you're going to have a problem.
For the last six years, that has meant our economy was on "tilt" in a way most people think of as positive: Huge investments in oil, plenty of credit for consumers. Now, the opposite kind of "tilt" looms right in front of us. The boom, as it was not financed with savings, will surely lead to a bust of similar magnitude.
Some folks have questioned why we've been following the oil sector so closely. This is why...
As Porter explained, problems in the oil sector are likely to be one of the big reasons for the return of higher capital costs...
Both car loans and oil investments are beginning to sour. These poor investments and poor lending decisions involved hundreds of billions of dollars in bonds and loans that have been packaged into bond-like securities. The worsening performance of these debts will eventually "spill over" into other areas of the bond market.
Here's how Bank of America high-yield credit strategist Michael Contopoulos explained the situation in a recent report...
We think we're seeing a pattern very similar to the late '90s emerge today. High yield typically overbuilds in one industry before realizing stress in that sector – think telecom then, commodities now. Over time, this develops into a risk aversion that spills into the broader market.
The stress has yet to make a meaningful impact to non-commodity sectors, but we view this lack of movement not as a positive, but just a delay of the inevitable. With heightened sensitivity to earnings, coupled with rate risk and further commodity weakness, we think poor fundamentals and demand for higher compensation for illiquidity will soon be reflected in prices.
Porter recommended keeping a close eye on high-yield bonds for clues on what's coming next...
The bigger trend is easy to see. Every investor in stocks should be watching the chart you see below. As I've been warning since 2013, the high-yield bond market reached completely unsustainable levels thanks to the Fed's massive credit inflation.
As this credit bubble deflates, "gravity" will return to our economy. Capital costs will begin to grow. Terms for credit will get tougher. The rising cost of capital will result in bad loans, bankruptcies, repositions, unemployment, softer demand, and lower securities valuations. Winter is coming, friends.
You can see commodity-related credit defaults have begun to hurt the market for high-yield bonds. Record levels of subprime auto loan defaults will be next...
If you're new to Porter's warnings above, you're probably asking what you should do. Porter explained in the July 31 Digest...
First and foremost, check your accounts and make sure you don't own any high-yield bonds.
As for other strategies... Watch your trailing stops. Consider shorting a stock or two as a hedge. And most of all, avoid companies that use large amounts of debt. Their costs are going up.
If you haven't been with us for long, you might also think he'd suggest selling all your stocks and moving entirely to cash and gold.
But that's not the case. As he told subscribers in the August issue of Stansberry's Investment Advisory...
You should know that even though we believe the actions of the Fed have caused some of the problems provoking the current economic climate, we're not expecting a full-blown calamitous 2008-like event in the stock market. We do, however, believe that a temporary period of deflation is upon us. And we do believe this will cause serious headwinds in the markets over the coming months.
We're more than six years into the current bull market. We've been cautious with our investments by recommending what we believe are high-quality stocks and companies that form part of a bigger trend. We want to own these stocks for the long haul...
The deflationary risks in the economy are real and significant. And our research leads us to believe that we'll see a serious correction in the market. But nobody knows the future. We don't hold a crystal ball. So we have to consider that our timing could be off. That means we want to remain long with our highest-conviction ideas to participate in a continued bull market.
In other words, if you own risky or overpriced assets, sell them (or at least tighten your trailing stops). But if you own high-quality stocks, we recommend staying long... and letting your trailing stops tell you when it's time to sell.
Why? Because as Porter said, no one can predict with certainty where the market is headed next.
There have been many reasons to worry over the past six years. The ongoing Greek crisis... the 2010 "flash crash"... the 2011 Japanese nuclear disaster... the 2011 (and 2013) "debt ceiling" crisis... the 2013 "sequester"... or the 2014 Ebola outbreak, just to name a few.
But if you had used any of them as a reason to sell, you would have missed out on the continuing bull market (as you'll read in today's mailbag).
Our advice remains the same: Stay long your "winners," selectively put new money to work in high-conviction opportunities, and consider selling some stocks short to "hedge" your portfolio... But just in case, keep your catastrophe-prevention plan in place.
Like Porter, our colleague Dr. David Eifrig isn't concerned about a repeat of the 2008 financial crisis. As he told DailyWealth Trader co-editors Brian Hunt and Ben Morris today...
There are times to worry about a financial crisis, but now isn't one of them. The U.S. economy is grinding higher. GDP growth is staying near 2% a year. Unemployment is falling. Construction spending is gradually improving. I see signs of improvement everywhere I travel. Flights and restaurants are packed.
But "Doc" believes the recent correction is a buying opportunity, rather than the start of a significant decline...
As for the stock market, it's reasonably priced in my view. We were way overdue for a stock market correction. In fact, the 3.19% drop on Friday is just one of 14 daily drops of this magnitude since this glorious bull market started. The last one-day decline of this size or more was way back in September 2011. So we've been due for a good cleansing "rain" like this for a while.
You don't need to be fearful. There's simply no reason to run scared based on all the evidence out there. The best thing to do in times like these is to put some stocks on your "watch list" – stocks that you'd like to buy if you can get them at a good price. And add to your investments when the market dips.
Still, Doc understands many folks are scared, or just aren't sure about what to do with their money next.
That's why, this Wednesday, August 26, at 8 p.m. Eastern time, he's holding a free, live "emergency briefing" for all interested readers.
Doc will share his latest thoughts on the markets, including which investments could be the most vulnerable right now... which look safest... and what investors need to know going forward.
Doc and his team have also put together a special research report detailing his three favorite current recommendations from his $1,500-per-year Income Intelligence service. And you'll receive a free copy with absolutely no obligation, just for attending.
Even if you aren't a paid subscriber to Doc's service – and even if you have no intention of becoming one – this online briefing, and the research report highlighting Doc's three favorite buys right now, are still available to you free of charge. Click here for the details.
New 52-week highs (as of 8/21/15): Short position in iShares MSCI Canada Index Fund (EWC) and short position in Viacom (VIAB).
In today's mailbag, a subscriber questions our market commentary. Send your thoughts to feedback@stansberryresearch.com.
"You would think after Thursday's and Friday's plunge, that [the] Stansberry Digest would offer some thoughts on the broad market action. Instead, you continue to pontificate on the oil market. I don't get it." – Paid-up subscriber David Sarricks
Brill comment: As mentioned above, we believe understanding the problems in the oil market is critical to understanding what's happening in the broad markets today.
That said, it's important to keep the last week's plunge in perspective...
Including today's decline, the Dow is down less than 8% since Thursday. The S&P 500 and Nasdaq Composite are each down the same. Yes, several individual stocks – including blue chips like Wal-Mart, Procter & Gamble, and Intel– have fallen more. But it's important to remember even these "boring" stocks have soared over the past few years. Even Wal-Mart – which has been heavily criticized for its poor performance recently – was up nearly 100% since 2012 without a major correction.
Corrections are a normal part of every bull market, and the market has been long overdue for one. So far, that's all this is.
Again, we can't be certain where the market is headed... which is why we always emphasize proper asset allocation, position sizing, and trailing stops to protect your capital. Sure, this might be the start of a more significant decline or a bear market... but it could also be just another fear-driven selloff on the way to new highs.
Much of what passes for financial "news" is simply noise. And unlike the financial media, we don't report on every market move every day. As we often say, our goal is to tell you what we would want to know if our roles were reversed.
As you read today, last week's moves have not fundamentally changed our stance on the market. But you can rest assured that we will let you know if and when they do.
Regards,
Justin Brill
Baltimore, Maryland
August 24, 2015
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