The Tide Is Rolling Out
Checking in on one of the most important trends in the world...'The tide is rolling out'... A critical breakout in interest rates... What rising rates mean for the markets now...
Regular Digest readers know it's one of the most important trends in the world today...
In short, the financial "tide" that has pushed U.S. markets higher since the financial crisis is now receding. For the first time in nearly 10 years, the Federal Reserve is not only raising short-term rates, it is now actively unwinding its quantitative-easing program. As Porter explained in the January 12 Digest...
Most investors don't know anything about this... But the Fed is quietly reversing course. It's draining the system of reserves. On October 1, the Fed began to allow its balance sheet to "run off" by $10 billion a month. That is, as the bonds it holds mature, it won't "roll" the assets into new securities. And so, for the last three months, the Fed has seen its balance sheet shrink by $6 billion a month in U.S. Treasury securities and $4 billion a month in mortgage securities...
The tide is rolling out...
I don't mean that rhetorically or as some kind of metaphysical prediction. I mean the size of the Fed's reserve decreases will accelerate for all 2018. Specifically, the amount of securities the Fed will no longer roll forward will increase at $10 billion per month for all of 2018. Doing the math, that's a $420 billion decrease in the size of the Fed's balance sheet in one year. That's a sizeable reduction in demand for both mortgages and U.S. Treasury securities.
And just as speculators enjoyed a one-way bet on the way up, they now have a one-way bet on the way down.
As this tide rolls out, we'd expect to see financial conditions 'tighten' as access to cheap credit dries up...
And that is exactly what has been happening. Interest rates – the "price" of money – have been surging to multiyear highs across the yield curve.
For example, on Monday, the yield on three-month U.S. Treasury bills jumped to more than 1.90% for the first time in nearly 10 years. As a result, short-term Treasury bills now yield more than the S&P 500 for the first time since the financial crisis.
And on Tuesday, the yield on 10-year U.S. Treasury notes – to which trillions of dollars' worth of loans, mortgages, and other debt is benchmarked – surged back to a new seven-year high of 3.08%.
As you can see in the following chart, the 10-year yield has now created a small uptrend of higher highs and higher lows from its bottom in July 2016. And as of this week, it has now broken out above its late-2013 high...
This trend is important for two big reasons...
First, as rates rise, government bonds will become a viable alternative to other assets again. If investors can earn an adequate return in risk-free Treasurys, riskier stocks and corporate bonds become relatively less attractive.
This won't happen overnight... But if rates continue to rise, it will create a stronger and stronger headwind for other assets.
More important, it means the corporate-debt crisis Porter has been predicting for the past couple of years is growing more certain by the day. As he explained in his latest update in the April 27 Digest...
The extremely low interest rate regime of the last decade (created by the Federal Reserve manipulating the credit markets) encouraged many companies that should have failed to continue to borrow money. As a result, there are now several hundred publicly traded corporations that cannot possibly repay their debts. These "zombie companies" cannot even afford their artificially low interest rates.
Several hundred American companies are destined for bankruptcy or are on the verge of it. The stock market hasn't factored in these problems, at all.
Nobody has paid much attention to these zombie companies yet, not even when major companies like toy retailer Toys "R" Us, suddenly liquidated. (When is the last time you can remember a major U.S.-brand being liquated? Not just bankrupt, but every last item being sold off at an auction?)
The market is going to focus more and more of these zombie companies for one simple reason: Interest rates are, for the first time in almost a decade, rapidly increasing... Many companies cannot refinance their debts at these levels.
To be clear, we don't expect a crisis to begin tomorrow...
While we expect interest rates to continue to move much higher over the next several years, they won't get there in a straight line.
In fact, as our colleague Steve Sjuggerud has noted, speculators are making record bets on higher interest rates today. So we wouldn't be surprised to see rates pull back in the near term.
But the "clock" is now ticking. The trend in interest rates has turned higher for the first time in years... And it's simply a matter of time before tighter financial conditions begin to "matter" to the markets.
Again, this doesn't mean you should sell all your stocks and move to cash...
There is simply no way to know when this bull market will end... and it could continue to move higher for months before it finally runs out of steam.
More important, as even Porter has explained, certain companies are likely to do well despite these problems.
Our advice remains: Raise some cash. Hold some "hedges." But stay long high-quality, high-conviction stocks, and let your trailing-stop losses tell you when it's time to sell.
If you're looking for more guidance in protecting your portfolio today, we'd also encourage you to learn more about our friend Dr. Richard Smith's TradeStops software.
As you may have heard, Richard joined Porter and Steve for a special live presentation last week where he showed exactly how TradeStops can help you make much more money while taking less risk in the same stocks you already own.
If you missed it, you can still watch a full replay at no cost. But please note, this recording will go offline tomorrow night at midnight. Click here to see it now.
The feedback on Porter's "ego" continues to roll in. What's on your mind? Let us know at feedback@stansberryresearch.com.
"Dear Porter, I appreciate the honesty with your words to Mitchel K. yesterday... For me and probably most subscribers, character is one facet why your subscribers stay with you. I don't agree with everything you say and at times you can be a bit bombastic.
"However, I read through the tone that appears abrasive to some for the simple reason I sense that the reason you write what you write is because you want the best for your subscribers; in other words, you want what is best for me.
"As I am still in learning mode (at 64), I hear your heart with your words (or to this effect): 'if the situation were reversed I would want to know what I am saying.' In other words, I trust both the man (his character) and his competence." – Paid-up subscriber Dennis M.
"Porter, I want to augment today's comment by Mitch K. In addition to your realistic comments re: Buffet, you are also practically the only financial journalist (indeed, journalist of any type) to publicly excoriate Jack Welsh for leading GE right down the tubes. The financial press continues to treat him as God's greatest gift to management, even while he led the company to the brink of bankruptcy (saved by the good old U.S. of A. and its taxpayers), and left it in the condition it finds itself in today. This was once the premiere industrial company in the world, and look where Welsh took it (no, it was not Jeff Immelt who took it there).
"If GE shareholders, and potential shareholders, had heeded your advice (as I did) they would have avoided the large financial losses that ensued. Please keep telling it like it is." – Paid-up Stansberry Alliance member R.J.L.
"Porter – Your essay and analysis on BRK was insightful and objective. I've argued that over the last few years that Berkshire's poor ROI, low growth rate of book value (that Warren used to say was his benchmark for performance) and lack of any dividends, now or ever, made the stock a chimera for anyone seeking an investment for the future. Your breakdown of additional financial details just confirmed that I wasn't the only one claiming the 'Emperor has no clothes'.
"I've often wondered why my skepticism was met with raised eyebrows and decided that one couldn't argue with past success. However, the past is not necessarily prelude to the future and BRK's recent large (and capital intensive, leveraged) purchases does not bode well for the kind of growth BRK investors seem to think will continue. BRKB has a trailing P/E ratio of 32/1. Earnings per share were posted at (2015) $9.77, (2016) $9.77, (2017) $6.43, (2018 projected) $6.10. Return on shareholder equity for 2017 was 4.6%, and 2017 book value was $141/per share with minimal growth projected for the next three years against a current price of roughly $1970/share (source: Value Line Investment Survey). The equity portfolio is pretty run of the mill with oils, airlines, banks and consumer staples composing most of the portfolio.
"If you presented those figures without identifying the company, I doubt an investor would want to bank his or her retirement on the performance, much less future potential. Only because Warren and Charlie did so well the first 2/3 of their BRK ownership and management do people sit in awe of their performance. But, as you pointed out, they're now returning to the mean. Nice work. Again, thanks." – Paid-up subscriber Doug L.
Regards,
Justin Brill
Baltimore, Maryland
May 16, 2018