The Volatility Panic of 2018

Is the tide going out?... Where's the big miss?... The volatility panic of 2018... This reminds me of Long Term Capital's collapse...

You probably don't remember where you were early on the morning of January 6, 2000...

But I (Porter) will never, ever forget...

Most people today don't remember how big or important Lucent Technologies was at the beginning of the millennium. It was the most important company in the world.

Spun out of AT&T (T) in 1996, just in time for the Internet boom, the total value of all of Lucent's outstanding shares (its market capitalization) exceeded $250 billion, making it one of the five biggest publicly traded companies.

It was the dominant maker of telecom equipment. Investors believed it was the leading manufacturer of bandwidth – the key commodity of the Internet. Finally, due mostly to its former parent company AT&T, Lucent was the most widely held stock in America, with more than 5 million individual shareholders.

Its shareholders, long accustomed to revenue growth and earnings "beats," believed they had decades more growth ahead of them, as the Internet became ubiquitous. Most pundits believed demand for bandwidth was doubling every six months. Belief in the limitless growth of the Internet saw the tech-heavy Nasdaq rise 85% in 1999, a huge move that followed a decade-long stock market boom. Lucent had done even better, soaring from around $10 at the time of its spinoff to more than $80 per share by the early 2000s.

That morning, I woke up very early...

It was about 4:30 a.m. local time. I was in San Francisco (again) attending yet another big conference for technology investors. I was staying on one of the highest floors of the big downtown Marriott hotel, way up in the fog.

Because I was still on East Coast time, I was awake when Lucent released its earnings. Nothing could have shocked the market more. Earnings were down year-over-year. Revenues fell by $1 billion. A billion-dollar revenue miss in the fastest-growing corner of the technology market?

Sometimes, someone really does come out and "ring the bell" when a bull market dies. Lucent's stock fell 28% that day. It dropped 80% that year and was down 98% by the end of 2002.

Only later, as the 'tide came out,' did the truth come to light...

Yes, demand for bandwidth was soaring, but demand for Lucent's products wasn't. The best new fiberoptic technology wasn't Lucent's. And Lucent's legacy "copper cage" equipment sales were collapsing. Lucent wasn't going to be a big winner in the Internet age. It was going to be a victim.

It only looked like a winner because it had been using a raft of dubious accounting and sales practices... Enron-esque things like financing the purchase of its equipment by start-up companies whose shares it was also buying... like heavily discounting equipment sales at the end of each quarter, and then at the end also promising to heavily discount future purchases in exchange for buying more equipment in the current quarter.

Later, in 2004, Lucent would pay a $25 million fine in a settlement with the U.S. Securities and Exchange Commission regarding more than $1.1 billion in phony revenue and $470 million in phony earnings it had booked during 2000.

But by then, the damage had long since been done...

The telecom equipment sector was ground zero of the Internet bubble and its aftermath. Between Lucent's earnings miss on January 6, 2000 and the bottom of the tech bubble in the fall of 2002, investors lost around $4 trillion in telecom equipment investments.

As big as those losses were, they were nothing compared with the losses investors experienced during the mortgage and banking crisis of 2008/2009. Once again, I was at an investment conference when the real firestorm erupted. And once again, I'll never forget watching it all begin to fall apart.

It was July 7, 2008...

I was staying on one of the highest floors at the Four Seasons Hotel in Mandalay Bay in Las Vegas, looking down the Strip at the emerging "City Center" complex that MGM was building.

City Center was the largest privately financed real estate project in U.S. history. If you were going to take one picture of the real estate bubble, my view that morning would be the one: The biggest, most debt-fueled real estate project in the middle of the biggest, most debt-fueled real estate bubble town of them all.

On the Monday following a long three-day weekend, the extent of Fannie Mae and Freddie Mac's troubles finally became clear to everyone. Ironically, it was a Lehman Brothers analyst who finally spilled the beans, saying publicly that the two firms would need billions in new equity capital to cover potentially hundreds of billions in equity losses.

Although my work didn't make CNBC, I had written exactly the same thing in my newsletter six weeks earlier. I didn't believe the companies had any chance to raise enough capital, though, which explained why I believed both stocks were guaranteed to go to zero. Barron's put my work on its front page, but the market didn't really move until Lehman Brothers finally said the same thing. Ironic, isn't it?

I sat in my hotel room that morning, wondering where it would possibly end...

It was a scary time. Three weeks later, in an action that has never been explained to the public, then-Treasury Secretary Hank Paulson met with an exclusive group of hedge-fund managers at the offices of Eton Park in New York City.

He told a group of billionaires exactly how the Fannie/Freddie crisis would play out – with the government taking on all of Fannie and Freddie's obligations, wiping shareholders out. Meanwhile, at exactly the same time, he was telling Congress and the public that the firms were "well capitalized."

That was, of course, only the beginning. As we now know, lending practices and home appraisals were riddled with fraud and malfeasance. But if you believe nothing else I ever tell you, trust me about this: The government isn't here to protect investors. It's here to feast on you. Whenever the next crisis starts, you'll know government officials are lying when their mouths are open.

I don't believe the market action this week presages a bear market...

It doesn't feel like the start of a new crisis. To be fair, when the market crashed more than 1,000 points on Monday, I was staying in a hotel again. (Do you sense a pattern?)

Only, this time, I wasn't staying on a top floor, staring directly at the epicenter of a bubble. I was staying at Rancho Santana, a gorgeous beachfront resort in Nicaragua, on a surfing vacation with my friend Steve Sjuggerud and a group of our best subscribers.

But seriously, where is the epicenter of this big bull market in stocks?

It's tech stocks like Tesla (TSLA), Netflix (NFLX), Nvidia (NVDA), Amazon (AMZN), and Facebook (FB). All of these companies' earnings have been good or great – even Tesla, whose business model I believe will eventually implode (but hasn't... yet).

Revenues beat expectations. Losses were below forecast. The other most likely blow-up, Netflix, is performing even better than anyone thought possible, adding an incredible 8 million new subscribers last quarter. Netflix was expected to add 1.25 million new U.S. users last quarter. Instead, it added 2 million. That's a huge beat.

In short, I haven't seen the "Lucent Moment" yet. It just hasn't happened. The only thing that was even close was General Electric (GE) finally facing the nightmare of its balance sheet. But trust me, nobody was riding that stock to glory. GE has played virtually zero role in the boom over the past 10 years.

What happened?

I asked Austin Root, our new director of research and Stansberry Portfolio Solutions portfolio manager, to analyze which stocks have suffered the most. Two sectors jumped out – oil and gas (down 19%) and semiconductors (down 18%).

The move down in oil and gas makes a lot of sense. These firms generally don't produce free cash flow (capital is constantly reinvested in building additional reserves), and a huge new wave of supply is coming, which means oil prices could easily slide back below $50. Oil is a volatile commodity. That's nothing new.

The move down in semiconductors is troubling... at first glance.

But guess what? The sector was up more than 50% last year. It's just no surprise that investors would take profits at the first sign of volatility. In fact, when we studied the correlation between how a sector fared last year and how it has done over the past 10 days, we found a strong correlation (except for oil and gas).

Semiconductors were up the most last year. The sectors up the least last year (up 17%, on average) have held up fine during this correction (down 1%, on average).

What's happening isn't really about the fundamentals of our market or our economy...

We haven't seen a collapse in any of the sectors that have been driving this market higher. What's happening is the result of the worst kind of investing... the biggest financial excess of this boom.

I warned about this in the October 13 Digest, titled "What Will Cause the Next Crash." Here's what I wrote back then...

Where has the money and credit gone?

Not into commodities. They've been in a bear market (until recently). Housing prices have rebounded, but they haven't gone crazy. And stocks have certainly gone up, but with a few notable exceptions – like electric-car maker Tesla (TSLA) – they aren't trading at bubble-levels.

We have good reason to believe that the bond market (and junk bonds in particular) are trading at highly inflated prices... But that's more a function of the government's manipulation of interest rates than capital flows. What financial asset has completely lost its grip with reality? Only one kind of financial asset is trading at all-time levels.

The bubble in this market – the biggest bubble of them all – is the size and amount of bets against volatility. These bets have made investors billions and billions of dollars as central banks' liquidity has crushed all measures of risk. Inexperienced investors have come to view this trade as a "can't-lose bet" in the same way firms believed that dynamic portfolio hedging could remove all risk from their equity investments back in the 1980s.

The amount of capital betting on low volatility has driven the Volatility Index ("VIX") – the Chicago Board Options Exchange's measure of market volatility – to record lows. (Last Thursday, it closed at 9.19, its lowest level ever.) For almost 30 years, this futures contract rarely closed below 10. In fact, that has only happened seven times before this year. But in 2017, the VIX has traded below 10 on 25 separate days.

I explained in that Digest that the biggest problem with this bubble in particular is that all of these bets are pro-cyclical. They're all highly leveraged to the market. So as the market falls, investors will have to sell immediately. As I continued...

This part of the market used to be only available to futures traders – generally large institutions. But beginning in 2011, exchange-traded funds ("ETFs") allowed individuals to own these same futures, probably without really understanding what they own. Today, around $5 billion is invested in VIX-related ETFs.

There are two big problems with these investments that no one seems to understand... yet.

First, even though the nominal amount of money invested in these funds is small compared with the stock market as a whole, these funds are invested into highly leveraged, pro-cyclical futures. These are the exact same kind of instruments that led to the panic in 1987.

But an even bigger danger lies in these particular kinds of futures. VIX futures are only guaranteed to synchronize with the VIX index on the day they expire.

On any other day, supply and demand drive their value. Ergo, if investors panic and sell their ETFs, supply won't be able to keep up with demand, and the prices of these futures will become skewed. During a real panic, the value of these ETFs will evaporate, producing an even more exaggerated and leveraged impact.

What's driving the market action today is a panic based on math, computers, and futures – not rational thinking...

Various algorithms and models are driving decisions based on the rules of ETFs and other models. Dealers are engaging in forced selling to balance their books (buying puts). Unfortunately, most folks didn't understand the correlations between so much money following pro-cyclical actions.

When other investors are acting greedy, we try to become as cautious as we can. In the August 4 Digest, I warned that a correction was certain within 12 months. I urged subscribers to raise cash. Last December, as bitcoin was hitting all-time highs, I placed a major gold order with my friend and legendary gold-coin expert Van Simmons of David Hall Rare Coins.

I had no idea what bitcoin prices would do, but I figured if everyone else in the world wanted to throw money at a digital currency, I couldn't go too wrong by purchasing the only real currency – gold – instead.

Today, we're seeing the opposite...

Investors are worried. It's possible – though not inevitable – that a real panic could emerge as forced selling leads to more volatility, which leads to more forced selling as futures dealers have to continually buy more equity puts to balance these trades. It's unclear what impact these new volatility-linked ETFs will ultimately have on the markets.

But as stocks go lower, so do the risks. And as stocks go lower, better and better opportunities will emerge. Don't begrudge these idiots for their madness. Revel in it. While lots of value is being destroyed, just as much opportunity is being created – for you.

My advice is simple...

Follow your plan.

You'll free up capital if the market falls farther by following your stops. That will give you "dry powder" when the smoke clears. Ideally, you've already put aside plenty of cash, and you have at least some non-correlated assets that will help buffer the madness.

If your plan isn't working, then you need to find a better, more balanced way to invest. We're happy to help. We have complete portfolios built for you in our Stansberry Portfolio Solutions product and a world-class former hedge-fund manager at the helm.

And for just a few more hours – until tonight at midnight Eastern time – you can take advantage of the biggest discount we'll ever offer on this product. The next time we open Stansberry Portfolio Solutions to new members, it will be at significantly higher prices. Click here to learn more.

This reminds me of what happened with Long Term Capital Management...

Back in August 1998, the market simply fell out of bed for no good reason. Sure, Russia defaulted on some debt. But that only mattered to folks like billionaire investor George Soros. It shouldn't have mattered at all to U.S. investors.

Still, the market crashed, dropping more than 500 points in one day. That was a record point fall at the time. Investors who had enjoyed nearly a decade of easy 20%-plus annual gains in stocks were in shock. But it wasn't the big one. There was a long way yet to go in that cycle's "Melt Up."

It seems highly likely that the kind of financial problems we're suffering today will end up being a lot like the muck-up at Long Term Capital. Everyone was selling because they knew Long Term Capital had to sell to cover its Russian losses. And what nobody understood was that Long Term Capital was leveraged 100-to-1... and owned $1 trillion in assets. That amount of selling triggered wave after wave of additional selling, and so on.

But the selling wasn't based on any fundamental problems in the economy. As soon as everyone understood what was driving the selling, the panic stopped. The bull market resumed. I bet that's what happens again this time around.

One last thing...

Many of you are probably looking for our annual Report Card.

Last week, we promised to publish our 2017 grades today. However, with the market as tumultuous as it has been, I decided it was more important to shares these ideas about the return of volatility.

However, the grading is done. We held a webinar last night to unveil the results. You can view it at StansberryReportCard.com. And we'll run the review we planned to publish today in Monday's Digest.

New 52-week highs (as of 2/8/18): Grubhub (GRUB), New York Times (NYT), and short position in Simon Property Group (SPG).

In the mailbag, an Alliance member recaps the trip to Rancho Santana this week. Did you join us down in Nicaragua? Let us know what you thought at feedback@stansberryresearch.com.

"Big kudos for the Stansberry Winter Investment Conference this week! Awesome combination of educational content, informal chit-chat time with Steve, Porter, and Stansberry analysts, and fun fun fun while volatility went wild wild wild! How did you all manage to plan melt-up and melt-down talks on the very Monday of the market's biggest volatility freakout in years? No one here broke a sweat.

"Some highlights: Meb Faber's views, data, and gifs, Sjug teaching us to surf, a chance to rock out on stage with him as the sun set over the Pacific, amazing non-stop food, and beach bonfires.

"Today a van load of new Alliance friends toured Granada, a volcano, a pottery school, a chocolate factory, and Lake Nicaragua's islands on a speedboat. We had the day tour of our lives and then heard the market fell another 1000 as volatility turned into correction! Afraid all the TradeStops alerts I ignored this week meant my hodgepodge portfolio from [The Total Portfolio], [True Wealth], [Stansberry Gold & Silver Investor], [True Wealth China Opportunities], [Stansberry Alpha], [DailyWealth Trader], Doc's income trades, [Stansberry's Big Trade], and my own takes on those themes meant a disaster, I finally looked at my portfolio – down less than 3% since it all started. I can hardly believe it, and if there had been time to make trades this week, I surely could have made a couple points instead. I must finally be learning something!

"All in all, this week was a grand adventure I'd recommend to every Alliance member, and a great reminder of what might be the most important investing lesson I know: ultimately, wealth is not about how much money we make each day, week, or year, but how much joy we make that money bring us. Thanks a million guys; if our roles were reversed I'd throw a 5-day foreign learning party for you too, but since they're not this testimonial will have to do..." – Paid-up Alliance member Arthur Zwern

Regards,

Porter Stansberry
Baltimore, Maryland
February 9, 2018