The Cracks Are Starting to Appear
Editor's note: The market continues to march higher. The "Melt Up" is in full effect. Volatility is at all-time lows. Investors have never been more complacent.
But make no mistake, the bull market can't continue forever. Eventually, the problems that have been ignored will bubble to the surface.
This weekend in the Masters Series, we're featuring an exclusive two-part interview with Stansberry's Big Trade senior analyst Brett Aitken. In today's installment, Brett explains why growing debt loads in the U.S. have set us up on an unavoidable crash course...
The Cracks Are Starting to Appear
Sam Latter: For folks who aren't familiar, can you explain the strategy your team uses in Stansberry's Big Trade?
Brett Aitken: Sure. The strategy is fairly simple. We're buying long-dated put options on highly troubled companies.
Buying a put option gives you the right to sell a stock at a specific price in the future. As a company's share price falls, the leverage we get by speculating through options means that our returns are magnified. Now, the returns vary depending on a host of different factors. But as I'll explain in a moment, you can make five to 10 times more money by using options than you would by shorting the same underlying security.
Sam: That strategy works better as the market is falling apart and investors are rushing for the exits, right?
Brett: Yes, you're right. But it's important to get in before the market turns. You see, options are really just a form of insurance. As you know, insurance premiums are at their lowest when disaster hasn't struck in a while.
It's exactly the same with option prices. You want to buy puts when they are cheap. That happens in a rising market when investors are complacent. And today, the market is close to hitting new all-time highs. The S&P 500 was up almost 10% in the first half of the year. Investors are getting very complacent. Fear in the market is low. That's great for us. It allows us to buy put options cheaply.
Sam: The bull market is going into "Melt Up" mode, to borrow a phrase from our colleague Steve Sjuggerud. How does the Big Trade strategy factor into Steve's thesis?
Brett: Like Steve, our team believes we're in the final innings of this historical bull market. And stocks could absolutely march much higher over the next year.
But it doesn't change the fact that problems are brewing beneath the surface for certain industries. Consider consumer debt, for example.
This simple graphic tells the story...
Total household debt in the U.S. just hit $12.7 trillion in the first quarter this year – an all-time high.
We now have more than $1.3 trillion in student loans outstanding. That's up from around $250 billion in 2003 – an increase of more than 420%. The problem is that many of these students borrowed to pay for the soaring tuition fees hoping that their degrees would lead to higher-paying jobs. But wage growth has been almost nonexistent. So many of these people will struggle to ever repay their loans.
We have another $1.2 trillion in auto loans, about 25% of which is subprime. Subprime is defined as borrowers with credit scores below 620. Many of these borrowers have little or no income. Lenders should have never extended credit to many of these people in the first place. And to makes matters worse, lenders have extended some loans to 84 months. We know this will not end well for lenders.
In just the last two years, we've seen the cracks starting to appear. Credit-ratings firm Fitch just reported that around 6% of borrowers have fallen behind on payments by 60 days or more. That's the highest level in seven years.
Delinquencies always increase before we see defaults. And the defaults are starting to rise. Investment bank Wells Fargo reported that the cumulative default rate as of January this year was more than 12%, the highest rate since 2010.
As of the end of last year, roughly one-third of all used-car trade-ins were underwater, meaning the owners held no equity in the vehicle. That figure is going to grow. It's a proven fact that borrowers with "equity" (meaning they owe less than the collateral is worth) are much better payers than those who are underwater. So when the novelty of having a new car wears off... and the bills start mounting up... and the borrower realizes he still owes $25,000 on a car that's only worth $20,000... the motivation to pay the car loan starts to wane.
Sam: And this is all happening while the unemployment rate is healthy. Bloomberg says unemployment is now less than 4.5%.
Brett: Exactly. It's right around the same rate it was in mid-2007, right before the market began to roll over.
Lenders are going to have to face much larger write-offs than usual. Yet so far, we aren't seeing them make appropriate provisions for write-offs. When they hit – and they will hit – it's going to eat up large chunks of their net profits. Some could see more than half their tangible equity wiped out. We've studied the major auto lenders and they all face huge, looming problems.
Adding to the problem is the car industry is battling a bear market. After eight years of booming car sales, sales have finally started to decline this year. It's going to get a lot worse before it gets better.
Rising delinquencies means more cars will come on to the market. Plus, new-car leases grew by around 60% between 2012 and 2015, according to JD Power. The consumer-ratings service predicts that roughly 7 million cars will come off lease over the next two years.
These two factors alone put enormous pressure on the used-car market. Investment bank Morgan Stanley forecasts that we could see anywhere between a 20% and 50% drop in used-car prices between now and 2021.
Naturally, given the problems in the auto sector, we see huge opportunities there for the strategy we use in Stansberry's Big Trade.
Sam: You've covered the problems facing the student- and auto-loan markets. But your team has also singled out the troubling growth in credit-card debt. Can you tell us a little about that?
Brett: Sure. Total U.S. credit-card debt sits around $750 billion today. That's still a little below the peak in 2008.
But the problem with credit-card debt is it's all unsecured. That means lenders can't repossess your house, car, or boat. All they have is the borrower's promise to pay. When times get tough for cardholders, credit cards and student loans are the first debts they stop paying.
Everyone needs a roof over their heads, so they'll pay the mortgage first. And they need to get to work, so they pay their auto loan. But the credit card has no urgency. That's why losses on credit cards are always much higher than other types of debt. When defaults on credit cards start to soar toward crisis levels, debt and equity investors flee from these lenders. We've seen it before, and we'll see it again this time.
The other thing that nobody ever talks about is that debtors are habitual. Many people who owe money on their credit card also owe money on their car, their house, or rent to their landlord, etc. So the problems can escalate much faster than people realize.
The next wave of defaults in these sectors is looming, as Porter has talked about in the Digest. We can't know the exact timing. But our bet is that it's not far away. That's why we're looking at opportunities now in these sectors, before the mainstream media catch on. Once the floodgates open, it's too late. You have to prepare now.
Sam: Those are just a couple of the areas your team sees for making speculative bets. Talk a little bit about the corporate wall of debt coming due over the next five years.
Brett: According to an S&P Global report, $4.2 trillion of rated debt is coming due through 2021. More than $1 trillion of that is "junk rated" – that's BB+ or lower.
Some of it doesn't fall due until 2019, 2020, or 2021, but companies can't wait until it's due. They need to refinance way before the due date. With so many maturities coming due around the same time, refinancing will become a competitive landscape. A number of these companies will struggle to find lenders that are willing to refinance at rates the companies can afford. So those most in need must get to the front of the line before they run out of options.
Look at the retail sector, for example. As of last month, more than 300 retailers had filed for bankruptcy in 2017, up more than 30% from 2016. We're seeing big names like electronics retailer RadioShack... appliance retailer hhgregg, which closed 132 stores... and women's clothing chain The Limited, which filed for bankruptcy in January and closed its doors for good.
Amazon and other online retailers have killed off many of these traditional "brick and mortar" businesses. And the bloodbath is sure to continue.
Sam: Meanwhile, S&P has downgraded more than 500 companies so far this year.
Brett: Right, and while that's less than what we had seen at this point last year, the trend over the past few years is up. S&P issued 369 downgrades in 2014, then 639 in 2015, and 966 in 2016. When companies get downgraded, it becomes harder for them to borrow money.
We're looking to profit from the companies with the weakest balance sheets and broken business models. We want the worst corporate credits in America... those that will suffer downgrades, or worse, end up defaulting on their debt, causing their share prices to plummet.
That's why we need to know which companies are most likely to default. That much is obvious. What's less obvious is that these companies must have substantial amounts of equity value remaining. We're setting our sights on companies that are far riskier than the market realizes.
The companies on our current "Dirty Thirty" list have around $500 billion total worth of equity and more than $700 billion in debt. If we are even half-right on our analysis, that equity value will collapse as the credit cycle rolls over.
We'll have plenty of opportunities. Of course, that comes with plenty of risk, which is why patience is critical to our success.
But one thing is for sure: Eventually – whether it's next week, next month, or next year – the house of cards will topple over. And people who have been following our work in Stansberry's Big Trade will be sitting on huge profits.
Editor's note: Longtime readers know we've accurately predicted the bankruptcy of General Motors, Lehman Brothers, Fannie and Freddie, and General Growth Properties. But Porter's latest prediction – what he believes "could make you more money than any other speculation of my career" – could dwarf them all. Get the details here.