The Hidden Downside to This 'Easy Money' Boom

The hidden downside to this 'easy money' boom... An update on 'Bizarro Capitalism'... A recipe for collapsing profits and crashing prices... How will all of this end?...

In today's Friday Digest, a quick review of one of my new favorite themes: 'Bizarro Capitalism'...

To preview the conclusions, you'll find below there's a hidden downside to global central banks' campaigns of endless credit expansion and zero interest rates: As capital costs disappear, so do profit margins.

Equity investors will surely cheer financial innovations that lead to rapid amounts of revenue growth. But bond investors – those dreary troglodytes – focus on cash flows. Trouble is, despite wondrous new products, massive investments in research and development, capital expenses (like plants and equipment), share buybacks, and gigantic acquisitions... most of America's top companies aren't producing additional cash flows. But they are producing a lot of new debts.

How will this end? That's the question I (Porter) will attempt to answer today.

Readers of a certain age may recall Bizarro Superman – the comic villain who was Superman's polar opposite...

(Truly refined readers will recall the Seinfeld episode "Bizarro Jerry," which adopted the same metaphor. Seinfeld's sometimes-girlfriend tells him she has picked a new man who is the polar opposite of him, "Bizarro Jerry.")

Bizarro Capitalism is my extension of these ideas. It means a system of exchange and property ownership where capital is free and therefore requires zero savings or profits to grow.

I first explained the macroeconomic foundations of Bizarro Capitalism in April...

In theory, the costs of doing business are limited to capital and labor. Technology has greatly reduced the labor inputs for most businesses. With nearly free capital and greatly reduced labor inputs... the costs of producing a widget or providing a service have plummeted across our economy.

That sounds great, right? Lower costs should equal bigger profits. But of course, there's also competition. When everyone has access to unlimited capital... and technology limits the per-unit cost of labor... economic theory suggests there will be a race to zero. No one will be able to make a profit because there's no scarcity of capital, and therefore no ability to increase relative productivity.

And... what has happened?

The last several years have seen the rise of companies that are experts at exploiting technology to reduce labor costs. Free capital and zero per-unit marginal labor costs equals a whole new form of capitalism that's genuinely unlike anything the world has ever seen before.

These are companies with massive scale, massive sales growth... and virtually zero profits.

As proof of these concepts, I pointed to Amazon (AMZN)...

Here was a company that had grown tremendously. Since 2013, the online-retail giant's revenues soared from $80 billion to $140 billion annually. Those are huge numbers.

And profits? There aren't any in its consumer businesses. Its corporate-services business (Amazon Web Services) makes about $1 billion a year currently.

So over the last three years, on revenues of $320 billion, Amazon made about $3 billion in profit – or less than 1% of sales. Nevertheless, it had invested an incredible $17 billion on acquisitions and capital improvements – before its $13 billion acquisition of Whole Foods Market (WFM). In total now the company has spent $30 billion on investments in it business... almost none of which are expected to make a profit.

The stock market loves Bizarro Capitalism...

Stocks in general have virtually never been this expensive before as measured by the ratio of share prices to revenues or profits. Bizarro leaders like Amazon and Netflix (NFLX) have seen their share prices explode. When Amazon introduced the Kindle e-reader that gutted the profitability of every other book retailer, the stock was trading for around $90 a share. Roughly 10 years later, it trades for more than $1,000 a share – an increase of more than tenfold.

But Amazon wasn't just targeting book retailers. Even though online retailing today only makes up about 10% of retail sales, the price competition it has engendered makes it almost impossible to maintain a profit margin in the sector.

Finally, investors are beginning to realize the downside to Bizarro Capitalism. As you can see below, the retail sector looks like a war zone...

This is just the beginning...

All of these stocks, and many others, will likely go bankrupt. And the recovery rates on these bonds will not be normal (around $0.45 on the dollar) because no one is going to buy these companies or their assets beyond their inventories.

But the biggest problems from Bizarro Capitalism will occur in the commodity markets. Virtually free capital has led to a huge increase in commodity production, from oil to corn.

Since July 2011, U.S. onshore crude-oil production has essentially doubled. The last time U.S. crude-oil production doubled, it took 25 years, from World War II until the mid-1960s. We've done it again in just six years. Corn has seen production grow by almost 50% since 2012, from 10.8 billion bushels to 15.1 billion bushels.

But what about consumption?

Since Bizarro Capitalism doesn't require anyone to delay consumption (for savings), there's no pent-up demand for any of this stuff. Oil and corn demand have barely grown. That's why prices have fallen so much. Bizarro Capitalism is a recipe for collapsing profit margins (like retail). But it's also a recipe for collapsing commodity prices. And that sounds good... until you understand more about how Bizarro Capitalism really works.

You see, even though the money doesn't come from savings, it still has to be borrowed. And the folks who lent all of this capital don't think of it as funny money. They think it's real. And they're going to want it back, with interest.

Back in April, I pointed to Deere & Co. (DE) as a primary beneficiary (in the short term) from Bizarro Capitalism...

The tractor manufacturer had lent farmers $38 billion to buy tractors and other items necessary for farming. (That explains the huge increase to corn production.) The Wall Street Journal noticed this, too. This week, it published a well-researched article, noting that John Deere had become the fifth-largest agricultural lender in the country...

[Deere] is providing more short-term credit for crop supplies such as seeds, chemicals and fertilizer, making it the No. 5 agricultural lender behind banks Wells Fargo, Rabobank, Bank of the West and Bank of America, according to the American Bankers Association.

Does that make any sense?

Should one of America's most important manufacturing companies be inflating the demand for its products by becoming one of the largest agricultural banks in the world? Isn't it obvious that these loans are going to lead to far too many tractors being sold, sharply lower corn prices, and, eventually, a new financial crisis in America's heartland?

Deere, like many manufacturers in this credit cycle, has used leasing, even more than lending, to sustain demand for its products. Since 2010, the value of Deere's outstanding leased equipment has soared, from less than $2 billion to almost $6 billion. The Wall Street Journal explained...

Deere accelerated its equipment leasing in 2014 when sales plummeted following almost a decade of rapid-fire purchases by farmers flush with cash. The leasing business has kept Deere from having to idle factories and has provided dealers with income from replacement parts and services for leased equipment.

[Leases] provided farmers with machines for one to three years for a fraction of their purchase price, alleviating the need for loans. A new tractor costing $250,000 can be leased for about $30,000 a year. That compares with the cost to buy with a loan, which would require a 20% down payment of $50,000 and more than $40,000 a year in payments for five years.

Trouble is, when you provide leases for equipment that make them much cheaper to own, you make it much harder to earn a profit selling the same equipment. Deere has seen its profit margins on its equipment sales fall from $5 billion to less than $2 billion. That's Bizarro Capitalism: plenty of revenue, but no profit.

Here's the real trouble...

Eventually, all of those leased tractors get returned. If they can't be sold quickly, Deere takes the loss. Over the last three years, the amount of equipment leased out by Deere is up 87%. But what have corn prices done? Nothing. So... what do you think will happen next, after three years of booming lease business and no profits from farming?

The stock market couldn't care less about these risks. Shares of Deere have moved from around $75 to more than $120 in roughly the last year alone. And right now, the bond market couldn't care less, either. Deere's long-dated bond (the 5.375% bonds due in 2029) is trading for $24 over par ($124) and yielding 3%.

How will all of this end?

Will Deere successfully use virtually free money (in the form of endless supplies of credit) to prop up demand for its tractors forever? Will U.S. oil producers be able to lower their operating costs forever? (Recently, the average breakeven price for high-quality onshore production fell from around $50 to around $40, a change that has forestalled bankruptcy for a large number of U.S. oil producers.)

My bet is no. And like I told you in April... sooner or later, the gigantic credit bubble that lies at the heart of Bizarro Capitalism will burst.

Of course, I can't give you a date to put on your calendar. But keep your eye on the market for high-yield debt. The credit market will see these problems coming long before the stock market does.

In the meantime, the cost of 'insuring' against these problems is near an all-time low...

Today, you can hedge your entire equity portfolio with a small number of long-dated put options trading at dirt-cheap prices.

But that won't be the case forever... When the stock market finally wakes up to these problems, it will be too late. Volatility will return – practically overnight – and put-option prices will soar hundreds or even thousands of percent as investors panic.

In other words, the best time to buy "hurricane insurance" is when the sun is still shining. And you have that chance today.

This is exactly what we've shown readers in our Stansberry's Big Trade service. But we've taken this strategy one step further.

We've identified the weakest, most troubled companies in the market today, a list we've dubbed the "Dirty Thirty." Each company on the list is heavily indebted and has serious flaws in its business model. These firms are likely to struggle even if the bull market continues longer than we expect... and they're absolutely doomed when the credit cycle finally rolls over.

If you're not already reading Stansberry's Big Trade, I urge you to take a closer look today. Click here to learn more.

New 52-week highs (as of 7/20/17): AbbVie (ABBV), Amazon (AMZN), Becton Dickinson (BDX), ProShares Ultra Nasdaq Biotechnology Fund (BIB), CBRE Group (CBG), Global X China Financials Fund (CHIX), WisdomTree Japan Hedged SmallCap Equity Fund (DXJS), Euronet Worldwide (EEFT), Emerging Markets Internet & Ecommerce Fund (EMQQ), iShares MSCI Italy Capped Fund (EWI), iShares MSCI South Korea Capped Fund (EWY), Facebook (FB), Barclays ETN+ FI Enhanced Europe 50 Fund (FEEU), National Beverage (FIZZ), iShares Core S&P Small-Cap Fund (IJR), PureFunds ISE Mobile Payments Fund (IPAY), Johnson & Johnson (JNJ), KraneShares Bosera MSCI China A Fund (KBA), Lindsay (LNN), Microsoft (MSFT), Nvidia (NVDA), Paysafe (PAYS.L), ALPS Medical Breakthroughs Fund (SBIO), ProShares Ultra S&P 500 Fund (SSO), Guggenheim China Real Estate Fund (TAO), TransCanada (TRP), Verisign (VRSN), and Weight Watchers (WTW).

The "Melt Up" rolls on... and our new highs list is growing. How's your portfolio looking? Let us know at feedback@stansberryresearch.com.

"This probably isn't the complaint letter you were looking for but here goes:

"Steve, Porter I sat through the [Melt Up] briefing a few weeks back and boy what a waste of time. I could have binged watched some Netflix but instead had to sit through a timely market update AND a free recommendation. To make matters worse you had to entice me with a special bundle of three premium advisories to take advantage of the situation. That money would've been better spent on fidget spinners. So far I'm 'only' up a lousy 2% on the entire portfolio. Come on what is the hold up?!?, I was looking forward to an early retirement.

"But seriously, the 3 newsletters are well written and the effort put in to present the potential reward (and risk) of each opportunity is appreciated. It's hard to pick a favorite but Stansberry's Big Trade narrowly ekes out the win. This is not meant to slight Dr. Sjuggerud's work. I like what's happening with the True Wealth Systems and [True Wealth] China Opportunities recommendations. They feel like I'm playing the latest and greatest fun video game. Stansberry's Big Trade is satisfying in a different way. There is an additional layer of strategy and tactics involved. It is more like playing chess against multiple opponents simultaneously.

"On paper, the Big Trade model portfolio doesn't look impressive... at least not YET. But now could be a good time to stock up on insurance while markets are at all-time highs and the VIX is near all-time lows. It feels like I'm rummaging through a financial thrift store keeping my eyes peeled for insurance bargains. Using the 'Dirty Thirty' as a guideline, I scan the option chains to pick the option that meets my risk tolerances. It will take a while, but I really hope the insurance part of my portfolio can achieve Prem Watsa like gains (at least in percentage terms). In addition to the helpful indicator updates each month, I hope Mr. Stansberry and team can share more motivating famous short seller stories in future issues." – Paid-up subscriber Wilson W.

"You guys must be loving this – it's easy to predict a pullback amid a gigantic run up – unfortunately Porter has seemingly changed his tone and it has cost me dearly up to now and probably going forward." – Paid-up subscriber Richard Banko

Porter comment: Sorry Richard, but how exactly have we cost you dearly? If you've followed our advice, the vast majority of your portfolio is still long and growing. Yes, many of our "portfolio insurance" positions – such as the short sales in our Stansberry's Investment Advisory newsletter or our Stansberry's Big Trade put options – have lost value. But as we've explained again and again, this is to be expected. During an ongoing bull market, most of these hedges will be a small drag on your portfolio.

But when the bear market finally arrives (and we simply can't know exactly when that will be) they'll quickly make up for this underperformance. This is particularly true for the dirt-cheap put options we're recommending in Stansberry's Big Trade. They'll benefit not only from falling stock prices, but the return of volatility from near-record lows.

In fact, we got a small taste of this during the "mini panic" back in May. While stocks fell less than 3%, rising volatility caused the value of our Big Trade positions to rise 17% on average. When a real correction arrives, they'll absolutely soar.

Of course, I can tell by the tone of your e-mail that you did not follow our advice. You likely ignored what we told you about the importance of position sizing and gradually building your positions over time. Instead, you likely put far too much money into these positions looking to make a fortune overnight. So tell me... what else would you have me do?

"Hi: I have a simple question. Are there ever any 'unpaid-up' subscribers reflected in the mailbag? Seriously, I love the diversity, quality and depth of the work produced, and it will be needed more than ever with the rocky times up ahead. Cheers!" – Paid-up subscriber Tom D.

Porter comment: Thank you for the kind words, Tom. As I've explained in the past, the phrase "paid-up subscriber" is a nod to Jim Grant, publisher of Grant's Interest Rate Observer – whom I greatly respect.

For decades, Jim has referred to his audience, which includes most of the world's wealthiest and smartest investors, as "paid-up subscribers." I believe it's a small distinction meant to remind the reader that he's reading a personal journal rather than a mass-market publication.

Regards,

Porter Stansberry
Baltimore, Maryland
July 21, 2017