This Number Will Tell Us When the Next Default Cycle Is Here

Editor's note: It's the greatest speculative opportunity Porter has ever seen.

And prepared investors could see incredible gains.

Today's Masters Series features the excerpted conclusion from Porter's recent conversation with Agora founder Bill Bonner.

In it, they discuss how to speculate safely... highlight one company in serious financial trouble... and explain why timing is so important...

This Number Will Tell Us When the Next Default Cycle Is Here
An interview with Bill Bonner, founder, Agora

Porter Stansberry: What we've discussed is not investing. It's speculating. And to speculate safely, you must have a couple things.

First of all, you've got to be diversified. That's why we're talking about The Dirty Thirty. We're not talking about one stock... two stocks... or three stocks. We want to be able to trade all these stocks over the next three or four years. And the timing of each one depends on when we believe its credit is going to come under the most pressure.

The other thing I want you to understand about the timing is this idea of credit spreads. This is very important.

The issue is... credit can't be refinanced when the credit spreads get blown out. That means, basically, the markets are closed to high-risk credits.

You saw this happen famously in 2008-2009. There was no subprime lending on autos or houses. There was no high-yield-bond refinancing. The markets were closed. So everyone who had to refinance at that point in time couldn't. And a lot of them defaulted.

A great example of that was General Growth Properties, which is one of the largest mall owners in the United States. It went bankrupt, not because it had a bad business, but because it had to refinance at a time when the credit markets were closed.

So we want to watch those spreads to make sure we're able to buy our puts when the spreads are tight and when the credit markets seem very comfortable.

Because we know that won't last. And when those spreads get blown out, we want to be able to sell those puts for a large profit.

In Stansberry's Big Trade, we're going to be watching those credit spreads every single day. At the peak of the panic in 2009, credit spreads were 22 percentage points. That was the difference between what high-yield bonds were paying, on average, and what the U.S. Treasury bond 10-year yield was back in the spring of 2009. Twenty-two percentage points. Could you imagine going to refinance your house and hearing the bank say, "I think it's great that you had a 5% mortgage, but now we want you to pay a 27% interest rate."

No one can afford it. And that's why the credit markets closed.

As recently as June 2015, the credit spreads between junk bonds and Treasurys was only about two percentage points. That shows you just how warped they have become and how many weak companies have gotten access to credit.

That's all going to change when those credit spreads get blown out.

One last thing, Bill. You'll know when the credit spreads are going to get blown out because the default rate will rise. This is very interesting.

The central bank can put all the money they want into bonds. And they can make the price of bonds go so high that they even have a real negative interest rate. But they can't make a bond pay. They can't make companies produce earnings that can finance these debts. This is the same thing that led to the collapse of the bubble in the mortgage world. Eventually, housing prices got so high that nobody could afford to buy them. There were no earnings to support the loans.

We see the exact same thing happening in the corporate-credit world today. That's why the default rate on high-yield bonds has already gone from close to zero in 2014 to above 5% as of August of this year.

Historically, that 5% has been the trigger for a new default cycle. Because as some corporate credit defaults, it makes banks toughen their lending standards. It makes investors a lot more risk averse. Of course, that tightened lending then causes even more defaults. And so the cycle begins.

As you know, Bill, these credit cycles are very powerful. They're bigger than the central banks. And what's interesting is, the bond markets dwarf the stock markets... And the bonds are more senior to stocks in the corporate structure... But very few stock market investors pay any attention to the bonds.

Bill: Yeah. Well, the bond market is traditionally more serious.

Serious investors, serious analysts are looking carefully at the bond market.

So it'll be interesting to see. You say the default rate is your trigger. That's what you're watching closely and that's the key to your timing.

Very, very interesting. I liked the whole idea, Porter. I think it might work.

Porter: Thank you, Bill. And one thing for people out there who might be considering this... it's really important to establish your positions in these put options long before there's any sign of trouble.

Think of it as buying insurance.

You don't want to wait for the hurricane before you start calling about flood insurance. The same thing is true here. You have to be able to see what the markets are going to be like in 12-18 months, and take action now so you can profit from those changes when they occur.

And Bill, as you know... the odds change instantly at the first sign of trouble. If you want to be able to protect yourself, this is the way to do it.

Let me be clear... This is a speculation. Like I said, I don't expect for us to make money on every single one of these positions.

But I think, overall, we're going to do very well... because of the nature of the amount of leverage you can have here. If you have 10 positions and you lose money on half of them, but you make 10 times your money, on average, on the other five, you're going to be very, very happy.

My suggestion, Bill, is that people take about 10% of their portfolio – no more – and put it into at least 10 of these trades over the next 12-24 months. If they do that, they should be able to safeguard the entire value of their equity portfolio from the next bear market.

Again, I think the worst-case scenario is that you're going to make a little bit of money on some of these speculations and lose a little bit of money on the others.

But the best-case scenario is... you can make 10-20 times your money on these trades, and you can safeguard your wealth. Or if you don't have any wealth to protect, this could be your first stop on the path to learning how to make a lot of money in the markets.

Bill: It sounds like a good idea, Porter. Somebody, sometime, is going to make a lot of money when this market finally crashes.

And it will crash, no doubt. You can't just keep adding equity like this, adding phony equity built on phony money delivered from the central banks. That's not going to work forever. So sooner or later, people are going to make a lot of money.

The question of timing is the big issue. And it's very interesting to see whether that default indicator holds up.

Porter: We're going to be watching it. We publish every month. And of course, Bill, I'll be sending you my research materials. My goal is to see if I can get you to personally make a couple of these trades along the way.

I think when you really look at some of these credit profiles and you see what they've lent against, you're going to be really shocked.

My favorite example is Cheniere Energy. Do you know the Cheniere story? It's a doozy.

The guy behind Cheniere was a very clever stock promoter. In the mid-2000s, you recall that everyone was hot and bothered about "Peak Oil." Even investors as knowledgeable and famous as Charlie Munger were saying publicly that the price of oil was about to spiral out of control because we were out of it.

And wouldn't you know it, less than a year later, we discovered all this shale oil, and U.S. production has soared since.

We've gone from making 5 million barrels of oil a day to making about twice as much in the United States. And of course, there are other shales in other places in the world, too. So oil production globally is way up, and as you know, the price of oil went from $150 all the way to below $40 for a time. Right now, it's settled around $50.

But the Peak Oil people really have a lot of egg on their face. And the guy who has the most egg on his face was the promoter behind Cheniere.

Bill, their plan was to spend about $10 billion to import natural gas into the United States. Because, don't you know, when you run out of oil, you're going to need to have a lot of natural gas to make electricity.

Well, this was like bringing sand to the beach. Because the United States – North America in general, the United States in particular – has the world's largest reserve of natural gas anywhere in the world.

There was no economic reason to do this. And in fact, the first five people who built liquefied natural gas (LNG) import plants in the United States all went bankrupt. But because the passion for Peak Oil was so crazy, this guy was able to raise $2 billion or $3 billion in equity and another $6 billion or $8 billion in debt.

He finished his plant. They opened their doors in 2009, right in the middle of the economic crisis, right in the middle of oil plummeting to below $40.

There was no business for this plant. So you'd think the guy would go out of business. He'd fold his tent. I mean that's it, we're done. We don't need to import LNG. We're going to go bankrupt like everybody else.

Oh, but no. This guy was such a clever promoter that he went back to New York and said, "I had it all wrong, but I've got it right now. We're not going to import LNG. We're going to export it. Because we have huge amounts of LNG. All I need is another $10 billion."

And what's amazing is, he got it. He borrowed another $10 billion.

So Cheniere today has $20 billion in debts. They've never produced any real profits. They've never produced anything but negative cash flows as they've continued to build this export facility.

And here's the crazy part... The only reason why LNG even existed was because it was against the law to export crude oil from the United States. They wouldn't let you take crude oil out.

Because obviously, crude oil is a heck of a lot easier to ship around the world than LNG, which you have to freeze to negative 270 degrees Fahrenheit and put under pressure to make it a liquid. So these ships are like giant refrigerated bombs. It's the most dangerous thing that happens in shipping in the world. And it's super expensive.

Forget all the refrigeration. Forget all of that stuff. You can just pump a bunch of crude oil onto a tanker. You don't need LNG anymore.

The guy got wiped out in 2009 when he didn't need to import LNG anymore. Well, then 2014-2015 comes along and the U.S. says, you know what? It's OK, you can export as much crude oil as you want. So just when he finally gets his plant turned around to export LNG, it's irrelevant because you can now export crude oil.

So here you've got $20 billion in debt. And you have no economic reason to support it. And that company still has an equity value of over $10 billion.

This is just a matter of time. And like you said, the timing is important. But we know there's no way this corporation can succeed because there's no economic reason for this business to exist.

Bill: That sounds like a good opportunity.

Porter: Thank you. And thanks for your time today, Bill. I hope you enjoy New York. I'd love to bring you out to the farm when we get it done.

Bill: Great. I look forward to it.

Editor's note: Cheniere is just one of 30 companies on Porter's "Dirty Thirty" list – big companies carrying huge debts that they have no chance of repaying or refinancing. And as the default cycle Porter has been predicting gets underway, speculators will have a chance to make 10-20 times their money betting against these debt-laden companies. Learn more about this strategy here.