Something Different as We Look Ahead to 2020

We're not joining the prediction-making party... But we are entertaining all possibilities... Something different as we look ahead to 2020... What would U.S. stocks have to do to surprise investors?... Never-before-seen territory in bonds... A potential value play in Europe... What's next for gold and gold stocks...

When it comes to the markets, I (Dan Ferris) don't do predictions...

It's way too difficult to predict both the direction and timing of securities prices.

But I do like to entertain competing points of view... I advocate what investment adviser and Stansberry Investor Hour podcast guest Mark Yusko calls "strong ideas, loosely held."

You do all your homework on an investment idea, develop a strong thesis, put some money to work... and always remember that you can be wrong. You must entertain all possibilities.

With the start of the new year just around the corner, many folks will make predictions.

But as we look ahead to 2020 in the next two Digests – today and Monday – instead of joining the prediction-making party, I'm doing something slightly different...

I'm going to break down 10 topics in the financial markets for investors to watch.

First, I'll look at these markets and try to figure out what's already priced in. Then, I'll entertain some thoughts about what would surprise investors in 2020 and beyond.

Let's get started at the top with U.S. stocks...

After its epic run, what would the benchmark S&P 500 Index have to do to surprise investors in 2020?

For now, the longest-running bull market in history keeps running... The S&P 500 is up roughly 375% from its March 2009 bottom. It's trading at an all-time high level right now.

Since its most recent low on Christmas Eve 2018, the S&P 500 is up more than 35%.

Investment bank Goldman Sachs (GS) said last week that the S&P 500 hasn't had a 20% correction in 10.7 years – the longest stretch in 120 years. And economist John Hussman recently noted that U.S. stocks are even more expensive than they were at the 1929 peak.

The record bull run and all-time peak equity valuations suggest investors are optimistic... and not expecting much bad news. So let's entertain the opposite point of view...

Let's define a market crash as a drop from 52-week highs of 30% or more in a single year. Stock market crashes are rare events, so it makes sense that most folks usually aren't expecting one to occur. It also means a crash is always a surprise.

If the stock market crashed, it might lead to a spiral of panic selling – in turn, possibly leading to a full-on, extended bear market that could take the S&P 500 down as much as 60% over a two- to three-year period. (From its 2007 peak to its 2009 bottom, the S&P 500 plunged nearly 60%.)

For perspective, the S&P 500 is around 3,200 right now. A 60% drop would put it at about 1,275. In other words, it would plunge to a level we haven't seen since 2011 and 2012.

With much of the financial press touting a booming U.S. economy and stocks reflecting that sense of optimism, a crash and ensuing bear market would surprise the living daylights out of everyone. It'd be great if it were that simple, but it never is...

You see, a big drawdown would not surprise everybody. Data from financial-research firm Refinitiv Lipper shows that investors pulled $156 billion from U.S.-focused mutual funds and exchange-traded funds ("ETFs") in 2019, more than any year since records began in 1992.

So plenty of investors still aren't in love with stocks today, even though they're hitting new all-time highs. Those investors pulling money out of stocks over the past year would likely be surprised by another few years of double-digit annual gains – like in the late 1990s.

I bet nobody is expecting that. (I'm not!)

One last thing...

The Chicago Board Options Exchange's Volatility Index ("VIX") – the market's so-called "fear gauge" – continues to sit well below its long-term average of around 20. Generally, anything above that level indicates that investors are fearful...

As regular Digest readers know, when stock prices move wildly, the VIX goes up. And when stock prices are calm, the VIX moves down. It's around 12 right now.

Stock price actions and the VIX suggest a big drop would surprise many investors. The exodus from mutual funds and ETFs suggests the opposite.

As I've said before, this wide range of outcomes is the perfect definition of risk. So preparing for a wide range of outcomes is your best bet here. As an investor, you can prepare by being adequately diversified among a few basic asset classes...

I've consistently recommended Extreme Value subscribers hold plenty of cash, as well as a 5% to 10% position in physical precious metals. And I've preached to them to only buy stocks when their share prices provide an adequate margin of safety.

That's a good all-weather strategy, and I see no need to change it as we head into 2020.

Now, let's turn to the bond market...

What will the global bond bubble do in 2020... and beyond?

I've been saying the global bond market was in a huge bubble for two years. That's still true today. The weirdest and perhaps biggest and most unknowable risks lie in sovereign debt...

In August, there was $17 trillion of negative-yielding debt in the world, most of it being sovereign debt in Japan and Europe. Today, there's less than $12 trillion of negative-yielding debt.

A $5 trillion change is a huge move... But make no mistake, $12 trillion is still a Mount Everest-like pile of debt priced for guaranteed losses.

And the problem is, we've never been here before.

Read Sidney Homer's epic tome, A History of Interest Rates, and you won't find negative-yielding debt once in 5,000 years. It's hard to have a feel for this, since we don't have any historical precedent.

For insight, I harken back to September, when the European Central Bank ("ECB") posted on Twitter: "Draghi: Negative rates will not provoke the collapse of the financial system." As I noted on this topic in the October 11 Digest...

Collapse? Who said anything about a collapse?!

It's a classic "we will not devalue the currency" moment, in which Mario Draghi – the outgoing president of the ECB – told us the truth by lying to our faces. Perhaps Draghi even knew we would really hear, "Yes, the financial system will collapse, but when it does, you can't pin it on me because I telegraphed it in this highly informational tweet."

It's like a fearful teenager who comes home from school one day, walks over to his mom at the kitchen table, and says, "If school calls and says I was absent today, they're lying."

Oh, yes, I'm sure you were there all day, mister. Now, march straight up to your room and stay there until every bond in the eurozone yields more than 0%! Kids these days. Oi!

It's Shakespearian: the lie reveals more truth than honesty. So Draghi has effectively telegraphed that negative rates come with huge risks... many of them unfathomable.

So what would the surprise be here? Maybe it would be a "soft landing" in the sovereign debt market... in which rates go positive without spiking up too high and without destroying the operating budgets of the countries issuing the debt.

It would surprise me if negative rates didn't lead to some awful consequences, though it's anybody's guess what they might be.

At least one central bank is trying to undo the negative rate regime...

Last year, Sweden's Riksbank hiked rates for the first time since 2011 – though they still remained negative. Then, this past October, Riksbank held rates steady but pledged to finally take them out of negative territory for the first time in five years.

Why do I care about Sweden, whose $550 billion gross domestic product puts it somewhere between the U.S. states of Michigan and Virginia?

Founded in 1668, Riksbank is the oldest central bank in the world and the fourth-oldest bank of any kind in operation. It has more experience and has survived longer than any other central bank and all but three other banks of any kind.

When the guys who've survived the longest say they're done experimenting with ultra-loose monetary policy, maybe Japan and the rest of Europe ought to listen.

Again, we can't predict the future... So we don't have any idea how this will ultimately play out. Cross your fingers that Draghi screwed up and accidentally told the truth in that Twitter post.

Negative interest rates have made it hard for European banks to perform well...

So that leads me into the next topic... Are European banks a value play?

As Philip Grant from famed investment newsletter Grant's Interest Rate Observer reported recently...

The Euro Stoxx Banks Index generated a 6.3% return on equity in the third quarter and trades at 0.62 times book value with a 5.8% dividend yield (that compares to an 11.8% third quarter [return on equity], 1.35 times price to book and 2.6% dividend yield for the U.S. KBW Index).

But look at all the European bank ETFs – like the iShares MSCI Europe Financials Fund (EUFN) and the German-traded iShares EURO STOXX Banks 30-15 UCITS Fund (EXX1.DE)...

Those two ETFs are up 18% and 26%, respectively, since they bottomed out in August, when the total amount of negative-yielding debt around the world peaked at $17 trillion. And they're still well below their highs, so they might have more room to run.

Given what Grant observed, it looks like there's substantial room for valuations to rise, too, putting a tailwind behind European bank stocks. And maybe, if the ECB takes the Riksbank's cue, banks will start earning better returns on equity as yields on securities and loans rise.

It seems likely that a year of stellar performance by European bank stocks would surprise the market, but it doesn't seem to be entirely out of the question.

When negative yields reign and banks suffer, investors often turn to gold as a safe haven...

With that said, after a productive 2019, let's consider what's next for gold...

Gold rose about 25% from less than $1,250 per ounce around this time in 2018 to a peak of more than $1,550 per ounce in early September. Then, by the end of that month, the precious metal fell back below $1,500, where it has spent much of the last quarter of 2019.

Given the optimism as gold rose throughout the summer, I doubt a move back above $1,500 would surprise anybody. At the same time, with all of gold's ups and downs over the past few years, I don't think another move down to $1,400 would surprise anyone, either.

However, I think a big move in either direction would raise some eyebrows...

If gold were to plunge down to, say, $1,200 per ounce – about 20% below its current price – it would surprise a lot of folks. So would a move to anywhere near the all-time high of $1,900 per ounce in 2011. That's roughly 30% higher than gold's price today.

Investors know gold can be volatile, and they mostly know to ignore the day-to-day "noise" in the space. So I believe it would take big moves higher or lower to surprise everyone.

Gold stocks are even more volatile, but some provide an interesting opportunity today...

The VanEck Vectors Gold Miners Fund (GDX) is up about 30% this year. It hasn't performed this well since early 2016... and it has slightly outperformed the S&P 500 so far this year, heading into the final days of 2019.

Regular Digest readers know gold mining is historically cyclical. And therefore, gold stocks are highly volatile. So it would be logical to expect a big move down after a big move up, similar to the metal itself... but with more volatility (bigger moves up or down than gold).

The real surprise in this market would be an extended bull run... stretching out several years, with few significant drawdowns along the way. For 2020, I believe that type of surprise could mean a modest 10% rise for GDX, uninterrupted by a big drawdown.

As I wrap up today's essay, I can't help pointing out a pocket of opportunity in gold stocks...

Small gold-mining companies that only own a few mines – maybe just a single mine – have cost structures that can be multiples higher than the larger miners.

So it pays for these small miners to get acquired by larger mining companies, who can lower their costs by spreading them over a larger asset base.

And beyond that, after suffering through many years of a bear market, a lack of new gold discoveries has set the stage for a supply shortage in the space. My colleague, Stansberry Gold & Silver Investor editor Bill Shaw, touched on this topic in his December issue...

Since gold exploration can take years of drilling efforts and economic feasibility studies to define a valuable deposit – and even longer to get the needed mining permits – it isn't something that can be turned on simply by flipping a switch. So it makes sense that many larger producers will start acquiring smaller producers or junior miners to replace reserves.

Buy some of these smaller junior mining companies today, and there's a decent chance you'll be able to sell out at a premium once a larger miner starts bidding on them. (Bill has identified a couple of possibilities in Stansberry Gold & Silver Investor. If you're not already a subscriber, you can learn more about the publication on our website right here.)

Heading into 2020, I have more confidence about continued mergers and acquisitions (M&A) in mining than in other sectors. That's because, as Bill noted, mining has no pricing power and is a low-return, capital-intensive business. Since the miners can't simply raise prices, they must focus more intensely on cutting costs to generate consistent cash profits.

The smaller miners have limits on how far they can cut costs. Bigger miners have more scale and can operate with lower costs. So it's logical to expect larger gold miners to buy up the smaller ones.

Having said that, it would surprise me if gold stocks didn't correct a bit in 2020, and if the M&A trend didn't continue. As you adjust your own expectations, remember that gold stocks are riskier than most stocks. They're more likely to deliver surprises than many others.

On Monday, we'll continue our look at the markets as we head into the new year. We'll start with a market that has whipped itself into a frenzy, one that looks set to continue in 2020.

New 52-week highs (as of 12/19/19): Alibaba (BABA), Blackstone (BX), Blackstone Mortgage Trust (BXMT), Quest Diagnostics (DGX), Electronic Arts (EA), Equinox Gold (EQX), Facebook (FB), Hannon Armstrong Sustainable Infrastructure Capital (HASI), iShares Russell 2000 Fund (IWM), JD.com (JD), Johnson & Johnson (JNJ), Microsoft (MSFT), Nordic American Tankers (NAT), Norilsk Nickel (NILSY), Nvidia (NVDA), Pan American Silver (PAAS), Invesco High Yield Equity Dividend Achievers Fund (PEY), ProShares Ultra Technology Fund (ROM), Southern Copper (SCCO), ProShares Ultra S&P 500 Fund (SSO), Sysco (SYY), ProShares Ultra Semiconductors Fund (USD), ProShares Ultra Russell 2000 Fund (UWM), ProShares Ultra Financials Fund (UYG), and Vanguard S&P 500 Fund (VOO).

In today's mailbag, more feedback on Corey McLaughlin's Wednesday Digest about financial literacy... Do you have a comment or question? As always, you can e-mail us at feedback@stansberryresearch.com.

"I just read your email about teaching finance in our schools. This should have been evident to educators years and years ago and I'm dumbfounded to understand why it hasn't been the part of every child's education starting early in school. Good personal finance habits should be repeatedly stated in every grade of school so that when ready to take on the responsibilities of an adult, good financial decisions would become a habit, rather than a challenge to maneuver over an unknown landscape trying to avoid mistakes and pitfalls while learning lessons all the way.

"I just appreciate you bringing this out. It's been a belief of mine for a long while now, and I wish those more influential than me would make this a project to present to our general educators." – Paid-up subscriber Ed P.

"Actually, I am going to tell you something a 6th-grade teacher taught our class. He gave each student $1,000 in Monopoly money and we had to buy five different stocks. Every Friday we checked the stock pages and plotted how we were doing. I remember I bought Disney and my friend got special permission to buy IBM as it was selling for $500. After one year we compared how we all did and I learned that buying and holding did better than the students who kept trading. To this day I thank that teacher for teaching me some practical math and hooking me on investing in the stock market. Over the last 30 years I have averaged 10.5% in the market and have a multimillion dollar portfolio." – Paid-up Stansberry Flex member Steven S.

McLaughlin comment: Thankfully, I had a similar experience around the same age. My social studies teacher, who was the department chairperson, went off curriculum and taught us about stocks. With his help, we tracked our investments each week.

The best performers received a quarter each Friday, if I remember correctly, and got to sit at the "winners table" the next week. At the end of the year, the teacher actually bought us one real share of a stock of our choice.

I picked Automatic Data Processing (ADP). Now, I just wish I had more than one share!

Good investing and happy holidays,

Dan Ferris
Vancouver, Washington
December 20, 2019