Masters Series: Porter Stansberry: Are You Playing the Right Energy Trend?

Editor's note: The Federal Reserve is stepping away from the market, reducing the volume of bonds it buys every month. And S&A founder Porter Stansberry says stocks could plummet as the central bank continues to taper…

In January, Porter spoke with financial publisher Streetwise Reports Energy Report about the macroeconomic climate facing North American investors. His forecast is grim.

In today's edition of our weekend Masters Series, we're featuring Part I of that interview. In it, Porter discusses what he thinks will happen if the Fed does not continue to support the market… and what he sees for the U.S. dollar in 2014.

Read on to learn the easiest and simplest thing Porter says you should do to protect yourself this year…

Porter Stansberry: Are You Playing the Right Energy Trend?
Interview from The Energy Report

The Energy Report: Let's start with an article that was published in the S&A Digest Premium December 20. [The Crux republished it for free.]

Porter, in that article, you state that you're bearish on the market, citing that when the U.S. Federal Reserve stops quantitative easing (QE), interest rates will go up. Rising interest rates could be a catalyst for a stock market crash. Your colleagues at Stansberry & Associates feel that short-term interest rates will allow the market to continue to run. To what extent are you in disagreement?

Porter Stansberry: We are in disagreement because I think the timing is important. Steve Sjuggerud in particular believes that the "Bernanke boom," which is the ongoing inflation of the credit market, will continue for much longer. He forecasts that before this credit market bubble bursts, stocks will reach much higher valuations, 25 or 35 times earnings. That's a lot different than my outlook.

I believe stock multiples, the price that stocks are trading as a multiple of their annual earnings, are going to decrease substantially as the Fed begins to taper and interest rates rise. Stock price multiples are negatively correlated with real interest rates. As interest rates rise, the market multiple will fall. I see stocks getting less expensive. Steve sees stocks becoming much more expensive. I can't tell you who will be right.

TER: What's the catalyst for rising interest rates, as there wasn't a reaction to the initial tapering?

PS: I studied what happened in the bond and the stock markets during previous periods when the Fed stopped manipulating the bond market. In every single case, the moment the Fed announced that there would be a cessation of intervention, stocks declined and interest rates went up.

The Fed is still buying $75 billion worth of U.S. Treasury debt. It is the world's largest holder of Treasury debt, holding significantly more than the Chinese and the Japanese.

The Fed is painting itself into a corner. If it does not continue to support the market, there is no doubt in my mind that prices for fixed income will go down. That means that yields will rise.

TER: What if the Fed very slowly tapers off the support?

PS: Let's just be clear about what happened: 10-year rates have gone from 1.6% last May to about 3% recently. Interest rates have almost doubled in less than a 12-month period. That is an enormous move. That changes the value of bonds significantly. It reduces the price almost by 50%. Folks who bought bonds that were yielding 1.6% have gotten killed.

The Fed's buying is far more important to the market price of U.S. debt than any other economic variable. If the Fed stops buying, it doesn't matter whether unemployment goes up or down. It doesn't matter whether inflation is higher or lower. Its influence on the market is dominant. You can't expect the market to have the same price when the guy who's buying $1 trillion per year of bonds steps away from the market.

TER: What's going to cause the Fed to step away from the market?

PS: Two things: There is overwhelming evidence that QE is not solving the country's economic problems. In particular, it is not increasing employment. There are 92 million Americans who aren't working. There are 50 million people on food stamps. That hasn't improved from the Fed spending $3.5 trillion on bonds. The rationale for this policy is nonexistent and the policy has been a failure. What the Fed is doing is economic suicide.

The Fed knows very well it's going to be incredibly painful to unwind. It has a ticking time bomb in its hands. The Chinese are running balanced budgets. They're running current account surpluses. They're buying up all the gold that comes up for sale around the world, and they're cutting bilateral currency agreements with every large economy in the world. All of this is laying the groundwork for making the yuan convertible in the capital account.

What's going to happen to the dollar's role as the reserve currency around the world?

TER: Do you see a significant devaluation of the U.S. dollar in 2014?

PS: That's a realistic scenario for this year. Time is slipping away from the Fed. If the Chinese make that step, the Fed is going to have a lot less flexibility. It has to get its house in order. It has to stop this wild experiment with the monetary base for the simple reason that our currency is in constant competition with others. We are at risk of alienating our partners who hold our currency in huge numbers.

Ask yourself a simple question: Do I think it's reasonable that the Fed will become the only global holder of Treasury bonds? That's the course we're on.

TER: If rates go up and markets go down in the U.S., to what extent does that also influence markets across the world?

PS: We're already seeing some impact… Emerging markets have gotten crushed over the last 12 months. More money is on the margin. A 3% yield is more reasonable to a banker than a 1.6% yield. As a result, money is coming out of markets where higher yields are available, like Brazil. And that is influencing bond and equity markets around the world.

If I'm right and the U.S. yields go to something like 5% or 6%, there will be an absolute catastrophe in emerging-market stocks.

TER: Would that mean lower stock prices in the U.S, and if the yuan becomes a stronger currency, higher stock prices in China?

PS: There will definitely be higher prices for Chinese equities. There are other key factors in the pricing of Chinese equities that need to be resolved, mostly the issue of the rule of law and the amount of transparency. China's equity markets have been badly damaged by the amount of accounting scandals the country has suffered during the past 18 months. I don't think there will be a quick or easy solution to that reputational problem.

TER: Then there really is no viable alternative currency to the U.S. dollar in the short term?

PS: The yuan is actually a very attractive currency and will prove to be very reliable – much more so than the U.S. dollar. I think the Chinese are going to come out with a gold-backed yuan, whether that is done legally or simply a de facto gold-backing due to the size of their treasury's gold holdings.

I think that they're going to offer a very high real yield. And I think that they'll do a good job, as they have done throughout the last 25 years in developing their economy. The problem, of course, is that the equity markets in China are not very well regulated and there has been a large amount of fraud.

TER: Newsletter writer Harry Dent believes the stock market will crash sometime between January and May. You expect a market correction. But where your views diverge is that Harry believes this crash will be followed by years of deflation.

He points to the aging world population and a natural inclination for reduced consumption as you age. You believe there will be inflation as a result of the massive international QE. On the surface, that's a demographic trend versus a monetary trend. In your view, how do these two factors play out?

PS: Harry – as much as I respect his long career as a publisher and as a pundit – is just completely off base. Inflation is always and everywhere a monetary phenomenon. I don't care how much the population of Zimbabwe has aged or hasn't aged. When you're doubling and tripling your monetary base every year, you're going to have runaway inflation sooner or later.

TER: So what's an investor to do?

PS: The easy and simple thing is to own short-term, high-quality corporate bonds, so you can hold things that are going to mature in a year or two. If you're getting 6% or 8% on those bonds, you're going to be protected from inflation. And you'll have the ability to roll them over at a higher rate so that you don't have anything to worry about.

To protect yourself from loss of purchasing power, you can buy high-quality common stocks that are trading at a reasonable price, but with the ability to increase prices. In my newsletter, I just recommended shares of Lorillard Inc. (LO), which is a tobacco company that has the leading e-cigarette franchise. You can still buy that stock at about eight times cash earnings. It's incredibly capital efficient. It pays about 60% of every $1 of revenue out to its shareholders in the form of cash dividends and buybacks.

Obviously, precious metals have long been a store of value in a period of inflation. You can buy gold and silver. You can buy real estate. I've been buying real estate pretty much continuously since 2010.

I started out by buying slum apartments in South Florida. I then moved into trophy properties as the volume in the market picked up and properties began to change hands. Most recently, I bought a farm. I borrowed some money at 4% and bought a producing farm that will pay for itself.

Assuming that interest rates in the U.S. go above 4%, I'll get the money literally for free. Of course, I also expect farm prices to increase, so hopefully soybeans and corn give me a good profit going forward.

I don't think there's going to be a crash. But I do think it's going to be very difficult for people who are heavily invested in very expensive stocks. Do you have any idea what the earnings-per-share multiple on Amazon is?

TER: Twenty?

PS: One hundred and fixty-six. Do you have any idea what Amazon's operating margin is? It's less than 1%, yet its shares are valued at 156 times earnings and more than 20 times book value. Investor expectations have become completely untethered to the reality of that business.

I'm not saying that Amazon is not a good business. It is. But at $180 billion and already dominating the U.S. retail industry, that company cannot grow fast enough nor can it possibly hope to increase its margins enough to justify investor expectations. The folks who are buying those companies are going to be sorely disappointed.

TER: You have an interesting measurement that plays along with this concept called the S&A Blacklist. It includes companies with more than $10 billion in market cap trading at more than 10 times sales. You use this to determine if the market is getting frothy.

PS: Over the history of the equity markets, the number of companies that have been able to significantly increase and hold their value once they have been so highly overvalued is very small. Most companies that trade at these kinds of enormous valuations are never able to justify the valuations. Even if the earnings grow, the stock price declines.

Yes, some of these companies will turn into the next Facebook or eBay, but most of them will not. The ones that can't are going to crash. We keep track of this list because at market bottoms, there are fewer than five companies anywhere in the world that are trading for more than $10 billion and more than 10 times sales. At market tops, the number of companies that meet those criteria can be more than 12. Today, there are 20 companies on that list, which is the highest number we have seen since the 2000 market top.

TER: To what extent is that number really just a reflection of having nowhere else to put your money?

PS: It's a very big reflection of that. The Fed has driven people out of the bond market. People looking for reasonable, safe investments have been forced into things like master limited partnerships and real estate investment trusts. They have driven investors into riskier and riskier assets. And it's increased the number of people who are willing to invest in stocks at insane prices.

Editor's note: The Energy Report's publisher, Streetwise Reports, regularly features interviews and insider commentary from commodities experts – like legendary geologist Brent Cook, chairman of Sprott Global Rick Rule, and Casey Research's mining and energy expert Marin Katusa. To read more from The Energy Report, click here.