Risky Junk Bonds Are Getting Riskier
Third-quarter earnings season starts with a fizzle... Don't expect the earnings 'recession' to end this quarter... Risky junk bonds are getting riskier... The best way to hedge today...
Earnings season officially begins...
Aluminum producer Alcoa (AA) kicked off the third-quarter earnings season before market open this morning.
It reported that earnings rose from the same period last year – the first time it has done so in five quarters – but revenue still fell year over year. But both earnings and sales missed analyst expectations, and the company lowered its outlook... sending its stock down more than 10% today.
Of note, this will be Alcoa's last quarterly report as a single company. It will split its aluminum mining and refining operations away from its aerospace and automotive businesses next month.
As you might assume, its raw-aluminum business has been hit hard by the decline in commodity prices. But the Wall Street Journal notes there are also warning signs for its aerospace business, via recent reports from industrial giants Honeywell International (HON) and United Technologies (UTX).
Honeywell saw a weak September thanks to a decline in orders for commercial aircraft, and it has slashed its sales and earnings forecasts. Meanwhile, United Technologies warned last month it would miss its full-year goals for one of its jet engines, which Alcoa supplies parts for.
Expectations aren't much better for the broad market...
Wall Street expects that total S&P 500 earnings per share ("EPS") will decline 2.1% this quarter, according to data from financial-research firm FactSet. As we've detailed in the Digest, this would be the sixth straight quarter of declining earnings.
If there's a bright side, it's that companies tend to beat Wall Street's average earnings estimates.
This quarter's estimate of a 2% loss isn't as severe as last quarter's, so some analysts are hopeful this means S&P 500 earnings could ultimately eke out a small gain for the quarter.
But we have reasons to believe that may not be the case this time.
Why the earnings "recession" could continue...
First, according to Goldman Sachs Chief U.S. Equity Strategist David Kostin, several factors suggest there will be fewer than average positive earnings "surprises" this quarter. As he explained in a note on Monday (courtesy of financial-news site MarketWatch)...
The conclusion is based on our analysis that utilizes five macro factors that have historically been correlated with earnings surprises: U.S. economic growth, interest rates, oil price, the dollar, and consensus [earnings per share] revisions.
Of the five factors, four have shifted in a direction that typically weighs on earnings surprises. Oil price change is the only factor that should positively contribute to third-quarter surprises.
Goldman expects earnings to decline another 1% this quarter.
Second, companies have been providing less guidance than virtually any time in the past 16 years. As the Wall Street Journal reported over the weekend...
Investors have less insight than usual with regard to how the results might play out. That is because companies have been particularly tight-lipped ahead of the customary reporting period.
By Bank of America Merrill Lynch's count, only 21 S&P 500 companies issued earnings guidance in September, a record low for any month since 2000. That is one-third lower than the average for a typical September, which is usually a light month, and roughly one-fifth of the overall monthly average. It is also lower than the Septembers of prior presidential election cycles.
In short, it appears companies may be following the old adage, "If you don't have anything nice to say, don't say anything at all"... And current expectations for a 2% decline in earnings may be too rosy.
As we noted above, one of the few companies to issue guidance recently was Honeywell... And its weaker forecast caused shares to plummet nearly 8% on Friday.
Earnings could soon "matter" again...
Earnings could be especially important for stocks this quarter because the broad market has become so expensive. As Porter explained in the September 30 Digest...
With the S&P 500 index trading at 25 times last year's earnings, a sustained decline in earnings will eventually trigger a rout in stock prices.
Excluding the massive tech-stock bubble in 2000, U.S. stocks have never been this expensive relative to earnings. And if you include corporate debt in these calculations (if you compare earnings with the entire enterprise value, not just the market cap), then you'll see that U.S. stocks have never before been this expensive in history. Trust me when I tell you... this bubble won't end any differently from the others. It isn't different this time. It never is.
Keep an eye on the technology sector in particular. FactSet notes that these firms are responsible for much of the improvement in earnings expectations this quarter...
Overall, 34 of the 66 companies in this sector (52%) have seen an increase in the mean [earnings per share] estimate to date. Of these 34 companies, eight have recorded an increase in the mean EPS estimate of 10% or more, led by Seagate Technology (to $0.79 from $0.37) and Applied Materials (to $0.65 from $0.47).
These two companies, along with Intel (to $0.73 from $0.64), Facebook (to $0.96 from $0.86), and Alphabet (to $8.63 from $8.35), have been the largest contributors to the increase in the projected earnings growth rate for this sector since June 30.
In other words, if these companies don't meet Wall Street's lofty expectations, it doesn't bode well for broad-market earnings.
More warning signs from the junk-bond market...
Today, we see yet another concerning development in the high-yield (or "junk") bond market. As Bloomberg reported this morning, junk-bond investors are now facing the worst risk-to-reward proposition at any time since at least 2014...
Investors that have been loading up on the securities as an alternative to ultra-low interest rates are now barely getting paid more than higher-ranking bank lenders, who would typically get their money back first in the event of a default. The difference in yields between junk bonds and the more senior leveraged loans is the narrowest in two years, data compiled by Bloomberg show.
Junk-bond yields have compressed so much that bond-market veteran Martin Fridson is warning that the market is more overvalued than at any time since the financial crisis.
Worse, investors are piling into this risky debt through even riskier vehicles: junk-bond mutual funds and exchange-traded funds. More from Bloomberg...
After hemorrhaging $45 billion in the past three years, mutual funds and exchange-traded funds that buy the risky corporate debt are on track for their first annual inflow in 2016, according to JPMorgan Chase & Co.
Investors plowed more than $2 billion into mutual funds and exchange-traded funds that buy junk bonds during the last week of September, the biggest deposit since mid-July, according to Lipper.
Longtime readers know these "investors" could be making a terrible mistake. Porter reviewed the dangers of these funds in last Friday's Digest mailbag...
The big secondary risk from the corporate defaults we're expecting are huge liquidity challenges that will be faced by corporate bond funds and exchange-traded funds.
Nobody is even thinking about this yet, but it's completely insane to offer daily or weekly liquidity (ETFs, mutual funds) for an asset class (junk bonds) that routinely "seizes up." Hundreds, if not thousands of bonds will simply not trade for months or years because buyers and sellers won't agree on a fair price. Huge sums of capital are invested in corporate-bond funds today... and these investors all believe they will be able to get out in time. They won't.
If you do nothing else with our work on these topics, at the very least make sure you don't own any junk-bond funds or mutual funds – or any funds that are even allowed to buy these kind of assets. They're going to get smoked. And investors won't be able to get any of their money back. They'll be trapped for the entire downturn. (See what happened to Third Avenue's Value Credit Fund last year for an example of what I mean.)
As a reminder, last year, Third Avenue shut down withdrawals from its high-yield bond fund. Investors in the fund had been promised the freedom to cash out at any time. Now, those investors are essentially at the mercy of fund managers.
According to the Wall Street Journal, the fund has been selling assets and has made two distributions to investors so far. But these folks still don't know when they'll get the rest of their money back... or how much of it will be returned.
Remember... this was just one fund that "locked up." When the default cycle accelerates, it won't just be one... It could happen to any and every fund that promises immediate liquidity but is invested in assets that can't be traded quickly.
The best way to "hedge" your portfolio today...
As Porter has discussed, he is hosting a free webinar next month to show all Stansberry Research subscribers a simple new way to "hedge" your portfolio from the growing risks he sees in the market today.
Porter says it isn't just the best way to protect your portfolio... It's also the best opportunity to make huge speculative gains he has ever seen in his career. He expects that subscribers could make 10 to 20 times their money as the credit default cycle rolls over and stocks and bonds begin to fall.
How to join us in London next month...
Finally, a quick reminder to end today's Digest...
As we mentioned last month, Porter is personally hosting a small group of subscribers on November 4-5 in London. He has organized a meeting at Claridge's, the iconic hotel in Mayfair, a group of tickets to a legendary football match – Chelsea versus Everton – and a VIP dinner with Erez Kalir, CEO of Stansberry Asset Management.
Again, the cost of the weekend is $5,000, which includes football tickets, transfers, and the VIP dinner. If you're interested in being a part of this small group, please contact Jamison Miller right here. But please note that we only have room for about 12 people, and nearly half the spots are already claimed.
New 52-week highs (as of 10/10/16): American Financial (AFG), KraneShares CSI China Internet Fund (KWEB), iShares MSCI Global Metals & Mining Producers Fund (PICK), Constellation Brands (STZ), and ProShares Ultra MSCI Brazil Capped Fund (UBR).
A light day in the mailbag... Surely, we've done something to please or upset you recently. Let us know at feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we read every e-mail.
Regards,
Justin Brill
Baltimore, Maryland
October 11, 2016