Our First Major Correction Warning Since 2010

It's a bull market, but will it last?... Our first major correction warning since 2010... How to prepare your portfolio...

It's a bull market (for now)...

Over the last 100 days, we've seen a remarkable series of big winners in our newsletters.

In Stansberry's Investment Advisory, we're up 87% on weight-loss company Weight Watchers (WTW)! We're up nearly 30% on Internet-networking company Ubiquiti Networks (UBNT), almost 20% on homebuilder NVR (NVR), and more than 10% on Tencent (TCEHY), the Chinese social-media giant. Over a slightly longer period, we're up more than 60% on Nvidia (NVDA), the hot semiconductor firm.

No, not all of the big moves came from my recommended list. This bull market is lifting all ships at a record pace. True Wealth China Opportunities holding and Chinese property developer Longfor Properties (HK: 0960) has almost doubled so far this year and is up more than 55% for subscribers. In only the last 30 days, aerospace contractor Boeing (BA) is up almost 20% for Retirement Millionaire subscribers. And three of Dave Lashmet's Stansberry Venture Technology recommendations have soared, too, up 20% or more in the past 30 days.

These are huge gains in a short period of time... in some cases just a few days... across dozens of stocks we've recommended buying this year. These recent moves complement the big gains we've seen across our model portfolios this year, like the almost 100% gain we've seen in e-commerce firm Shopify (SHOP) from The Total Portfolio, the 50% move higher in the KraneShares CSI China Internet Fund (KWEB) from The Capital Portfolio, and the 30% gain in property and casualty insurer Allianz (AZSEY) from The Income Portfolio.

How do you explain such big moves?

I (Porter) don't want to downplay the role our team of analysts has played in finding these investment ideas...

In the case of Ubiquiti, for example, we found the company using a huge database (see our Capital Efficiency Monitor in our Stansberry Data product) that we've spent five years building. NVR is a company that we've followed closely and written about dozens of times over the last decade. Weight Watchers is another long-term case study for us, also discovered from our work in the Capital Efficiency Monitor.

But... there's also no doubt that the extreme steep ascent of these stocks is primarily the result of a bull market that's reaching its "terminal" phase.

How much longer can this go on?

No one knows. But for the first time since 2010, we're now hitting levels on our complacency indicator that suggest a market correction is imminent...

This is an important and powerful indicator, so I want to explain what it measures and why it has been such an accurate indicator of market corrections and bear markets.

This indicator is a composite of several different gauges of market fear. As you know, we write about the Volatility Index (or "VIX") frequently. The index – which measures the prices investors pay for options that protect the value of their stocks – is one good way to measure fear in the market. But it's not the only one.

There are other similar gauges, some of which measure fear in even more important markets, like the global currency markets and the global credit markets. By studying these numbers from across dozens of different market cycles (25 years' worth of data), we've discovered a key threshold level. When fear drops below this level, a correction (defined as a drop of more than 10%) or a bear market (a drop of more than 20%) has followed every single time, within 12 months.

This indicator hasn't warned about every correction. (It correctly warned about seven of the last 10.) But it hasn't produced any "false positives," either. In other words, while it doesn't spot every correction before it arrives, when it has told us that a correction is coming, the correction always does. (To be perfectly accurate, one of the resulting corrections only saw a decline of 8.4%. All of the others were in excess of 10%.)

You can see the key threshold level in the chart above. Drops in measures of fear below this level (30) always indicate a correction or bear market within 12 months. We don't know if the warning signal we're getting now means that the "big one" is imminent, or if we are only going to see a "small" correction. But we know something is coming. We know it's coming soon. And we know that there are huge excesses in the credit markets, in particular.

Subscribers sometimes complain...

They say that that while we do a great job of documenting the risks in the market (like the auto-lending bubble), our "timing" is usually early.

Well, our complacency indicator was built to address that issue directly. We've watched as huge amount of bad loans have been underwritten, particularly in 2014, 2015, and 2016.

We can't know exactly when this bad debt will really begin to explode... But our complacency indicator says that it will happen sometime in the next 12 months.

So what should you do with this information?

It's very simple: Raise cash. In The Total Portfolio, I'll be raising our cash levels from just above zero to around 30% over the next 30 to 60 days. With about 40% of the portfolio in fixed-income (or equity similar to fixed-income), that means that we will end up with 70% of portfolio either in cash, fixed-income, or fixed-income-like securities.

That's a big war chest of liquidity to sit on while we wait for the inevitable opportunities that will arise. And by the way, nothing is wrong with taking profits when you're up 50% or 100%. We'll do so by tightening our stops and/or by selling covered calls against our positions. Don't forget you can get paid to sell your shares.

We'll also expand our short book. Right now, about 10% of the portfolio is short. I will probably increase that short allocation by another 5% or 10% of the portfolio based on the number of opportunities we can find. Going into a bear market with 70% of the portfolio in cash or fixed-income and 20% short... that will make sure that we can continue to produce gains (or at least break even) as the market falls.

But we won't sell everything. We will do our best to hold on to our highest-quality businesses, which will continue to produce cash almost no matter what happens to the economy or the market.

Earning big gains during a bull market is exciting...

And it can make you very, very wealthy. But the real challenge is hanging on to those wins during the corrections and bear markets that follow. I succeeded at doing so during the last big bear market in 2008 and in the 2002 meltdown, too. In both cases, our short book (the stocks we've sold short before the big break) saved us. I'm confident that will prove to be true again this time, too.

One last sign about the likelihood of a market correction or bear market this fall...

I compete in the White Marlin Open. It's the world's richest fishing tournament, held every August in Ocean City, Maryland. (This year's tournament starts next week.)

The tournament awards millions in prize money to whoever can catch the biggest white marlin, with the winner taking home something around $3 million.

I've got a top-notch professional crew and a boat with a tournament-winning pedigree. We've been to the White Marlin tournament weigh station (only the biggest fish are boated and weighed) four different times. And we caught the second-biggest white marlin two years in a row (2014 and 2015). Hopefully, this will be our year. You can follow all of the action at the weigh station here. And you can follow the action on my boat Two Suns by following our community page on Facebook here.

Obviously, this is an expensive hobby. The fishing is done far offshore (up to 100 miles) over the big deepwater canyons off the East Coast. That means big and fast boats are required just to get to the fishing grounds.

To outsiders, a competition to catch the biggest fish seems like luck. But more than half of the winners come from the same group of professional fishermen from North Carolina, and virtually every winner comes from a professional, full-time crew. While you can get lucky and win on your own, it's far more likely that a professional crew will win the big money. Entering all of the different wagers costs more than $50,000 – not counting the cost of fuel, the crew, and all of the gear.

These factors discourage all but the best-financed and most dedicated crews from participating. So it's unusual for more than 300 boats to be enrolled in the tournament. In fact, that has only happened once before, back in 2007.

This year, more than 400 boats are expected to enter the tournament.

We did some practice fishing out in the Washington Canyon last week. We caught five white marlins and one tuna that was close to 100 pounds. If we can do the same next week, we have a great chance of winning. Wish us luck!

New 52-week highs (as of 8/3/17): AMETEK (AME), Allianz (AZSEY), Baidu (BIDU), Berkshire Hathaway (BRK-B), iShares MSCI Italy Capped Fund (EWI), iShares MSCI Japan Fund (EWJ), iShares MSCI Singapore Capped Fund (EWS), National Beverage (FIZZ), iShares U.S. Aerospace and Defense Fund (ITA), Nuveen Preferred Securities Income Fund (JPS), Lockheed Martin (LMT), NVR (NVR), Travelers (TRV), Invesco High Income Trust II (VLT), short position in AutoNation (AN), and short position in Brinker International (EAT).

In today's mailbag, more success with put options... and a subscriber has a question about the Federal Reserve plan to "unwind" its stimulus programs. As always, send your questions and comments to feedback@stansberryresearch.com.

"On Dan Ferris' advice to sell short EAT a couple of Extreme Value issues back I bought 5 Jan 18 $35 puts for $ 118 each or $590. Here we are today and they are worth $1,672 for 183% gain as EAT sells for just below $35. I am just writing in to Porter to say thanks for introducing the long dated put as an alternative to a short sale in Stansberry's Big Trade. It is a so much less complicated idea and you know up front what you can lose. Yes, there is the time value issue of options but the trading costs are low and you can roll them over if you need more time. And to Dan Ferris for the astute call on EAT.

"If you get 183%, I guess you just take it or at least get your money off the table. I just love these little wins. It ain't The Total Portfolio but hey you can send the grand kids a little walking around money. And it shows you what can happen if we do get at 20% pull back if you are in the Big Trade. Thanks. 'Picking up nickels in front of a steamroller.'" – Paid-up Stansberry Alliance member John Prather

"You keep talking about the Fed unwinding its balance sheet, but how is this actually going to affect stock, bond, and gold prices? For T bonds, is TBT or TLT the correct trade? Interest rates go down because of all the new bond sales? Thanks." – Paid-up subscriber Ted S.

Brill comment: As we've discussed, the Fed has been a big source of demand for U.S. Treasury bonds over the past several years. Following the financial crisis in 2008, it began "printing" trillions of new dollars to buy Treasurys through its quantitative-easing (or "QE") programs. By 2014, it had bought up nearly 20% of the U.S. government's outstanding debt.

The Fed officially halted QE three years ago. Since then, it has maintained its balance sheet by reinvesting the proceeds of maturing bonds back into new debt. But recently, the Fed said it's ready to stop reinvesting and let its balance sheet start to shrink.

Now, this QE "money printing" arguably did little to help the real economy. But it clearly boosted asset prices...

And if quantitative easing helped push prices higher, it's only logical that quantitative "tightening" would pull them lower.

As the Fed begins to unwind, it will likely create significant headwinds for both stocks and bonds. Because bond prices and yields (interest rates) move inversely, this means long-term rates are likely to move higher.

Precious metals are a wild card... They also moved higher following the Fed's first round of QE in 2008. But they began to diverge in 2011... While stocks and bonds resumed their ascent, gold and silver began a brutal four-year bear market.

In hindsight, it was right around this time that public belief in the economic recovery began to take hold. Until then, most investors were simply waiting for the other shoe to drop. When viewed through that lens, this divergence isn't surprising...

We'd expect "disaster insurance" to soar during a crisis, and move lower when the danger passes.

Of course, we believe it's just a matter of time before it becomes clear that this recovery was built on a foundation of unsustainable debt. Another crisis is inevitable. And the higher interest rates that are likely to accompany the Fed's "unwinding" will only hasten its arrival.

Regards,

Porter Stansberry
Baltimore, Maryland
August 4, 2017