What Will Cause the Next Crash

What will cause the next crash... The biggest risk to financial assets today... What regulators and investors are missing... Don't be the sucker...

There's a huge risk that's being hidden by the current bull market...

It's not inflation. It's not accounting fraud. It's not about overvalued stocks.

It's something that's so technical and so difficult to understand that regulators, individual investors, and even the most sophisticated institutions are missing it.

But this risk is HUGE. And it's staring us right in the face...

In today's Friday Digest, I (Porter) am going to tell you about this enormous threat to financial assets and explain why this is what will eventually destroy most of the wealth people believe they now hold in the stock market.

I hope you'll keep a copy of this week's Digest. I believe this essay will eventually become well-known as the most prescient thing I've ever written about finance.

If you want to understand the biggest risk in finance today, you first have to spot the biggest bubble...

Inflation is a poorly understood financial concept. It has nothing to do with price indexes (like the consumer price index or the producer price index). Belief in those measurement tools stems from the 1970s, when inflation flowed into hard assets and commodities.

The big inflation in the most recent bubble was in residential housing. That should have been obvious to everyone... But it wasn't because we don't call home prices rising much faster than incomes "inflation." We call it the "wealth effect." (Trust me, it's still inflation.)

So... what's the proper definition of inflation?

That's simple: Inflation is the creation of money and credit beyond the savings rate. We have a central bank that creates trillions of dollars of new money with the click of a computer mouse. These funds, produced without any savings, taxes, or increases to productivity, flow through government spending and mortgage finance.

The government's spending on defense contractors, the medical community, the housing complex, and all of the associated "swamp creatures of the beltway" isn't the real problem. Those are only the first-order impacts of these policies.

You see, the real impact of this new money comes when it enters the banking system. Firms like JPMorgan (JPM) can take $100 million in new government bonds (a reserve asset) and then lend out another $900 million or more in new commercial credit. That's how a real credit bubble is built... by the accumulation of trillions and trillions in new credit.

We've seen this credit inflation occur over and over, ever since we abandoned the gold standard in 1971...

Gold provided a physical limit to credit. Since gold reserves had to be mined, they couldn't merely be wished into existence.

As interest rates have moved lower and lower, the size and scope of the credit bubbles have become bigger and bigger. More borrowing can be financed thanks to the much lower borrowing costs.

Likewise, as interest rates have fallen, vastly more credit could be extended to the most marginal parts of society. Subprime lending only works when institutional credit is available at rates of less than 5% a year.

(Subprime borrowers typically default on 10% or more of these loans, and it's difficult to charge anyone more than 20% a year to borrow money. Ergo, for the business model to work, funding capital must be available at less than 5%, otherwise no operating margin is left to run the business and make a profit.)

Falling interest rates have made each bubble worse than the last...

The commercial real estate bubble of the late 1980s was tiny compared with the tech-stock bubble of 2000... which was less than one-tenth of the size of the mortgage credit bubble of 2007.

With institutional funding rates now close to zero – or in some cases, below zero – the current bubble will be the worst and most disruptive yet. The next bust will feature far more civil unrest because it has largely been built upon the middle class and the poor.

This credit bubble has seen HUGE amounts of debt added to the accounts of major Western governments (middle-class taxpayers), students (student loans outstanding sit at more than $1.5 trillion), and subprime borrowers (auto loans and credit-card debt each total more than $1 trillion).

As the amount of debt that must be serviced continues to grow much faster than wages, it's simply a matter of time before defaults overwhelm the ability of creditors to pay. At that point, the cycle will reverse... And the crash will come.

None of this is new... or should be news to you...

We've been reporting on these facts for a long time, since we noticed auto lending in particular begin to get out of control back in 2014. Since 2008, the major Western economies have experienced massive inflation. At least $20 trillion has been created in new credit in the U.S. alone, counting new federal debt, new consumer debt, and new corporate debt.

So... in less than 10 years, we've created more new debt than what our entire economy produces in a year. That's an inflation that's bigger than any in our history outside of World War II.

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.

Where's the biggest bubble?

What financial asset has completely lost its grip with reality? Only one kind of financial asset is trading at all-time levels.

Last week, I attended the speakers' dinner at the Grant's Interest Rate Observer Fall Conference in New York. The room was filled with billionaires and a few folks who "only" manage billions. I had a long conversation with Frank Brosens, one of the founders of Taconic Capital, a major hedge fund. Brosens spent the 1980s serving as the head of risk arbitrage at investment bank Goldman Sachs, where he was a general partner.

At the conference, Frank told the story of how his group made billions on the crash in 1987. They perceived how the so-called "portfolio insurance" programs that were being sold (essentially dynamic put-buying) would lead to a cascade of selling in the stock market as too many market participants had adopted "pro-cyclical" – meaning positions that tend to propel market reactions into overreactions – instead of "counter-cyclical" strategies.

You see, the guys buying the "portfolio insurance" didn't understand that not everyone can hedge their portfolios at the same time. Someone has to be willing to sell the put on the other side of the trade.

Frank and his team started calculating what would happen in the event of a 5%-6% correction in the stock market as these trading programs kicked in, and they began buying massive amounts of put options at the same time. He explained they calculated there would have to be a 25%-30% correction in the markets, based on the amount of puts that would be purchased.

Few people perceived this risk...

Almost nobody considered the fact that lots of insurance companies and pension funds had entered into pre-programmed dynamic hedging strategies. But these orders represented a gigantic "stop loss" point that was sitting just below the market. Trip over that level, and look out... billions and billions of stocks would be dumped on the market. Everyone would try to exit at once.

Brosens' team did something brilliant. It began offering insurance firms an extra percentage point in annual return on their entire portfolio in exchange for the right to sell them a percentage point worth of stocks at the current (fixed) price.

The insurance firms were so excited about an extra point of return that they began to bid the deal higher. Soon, Goldman Sachs was getting three points of stocks (at the current price, fixed) in exchange for only one point of extra return for the insurance companies.

You might not understand the math... but the impact of these deals was that Goldman would get a return of up to 300 times on its money if the stock market fell by a certain amount.

You know what happened next...

But you've probably forgotten why.

On Thursday, October 15, 1987, Iran hit a super tanker in the Persian Gulf with a Silkworm missile. The ship was U.S.-flagged and carrying crude oil bound for the U.S. market. On Friday, October 16, it happened again. Iran attacked another super tanker.

The market responded badly. Selling led to more selling... and then even more selling. The dynamic hedging programs were driving more and more money out of the market as it fell. The market fell more than 300 points by the end of that week, down about 12%.

The sell orders piled up over the following weekend as the London Stock Exchange didn't open because of a freak storm. A hurricane hit southern England and northern France. More and more investors began to panic. When trading opened in New York on Monday, October 19, it seemed as though the entire world wanted to sell stocks at virtually any price. The market crashed an incredible 22% in one day.

Brosens and his team at Goldman Sachs saw what was going to happen...

They were ready. And they made billions by hedging Goldman's other trading losses. They probably saved the firm.

He explained to me that the exact same forces are now at work in the U.S. equity markets, thanks to massive bets against volatility. 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.

One anecdote making the rounds in the market today is about Seth Golden, a logistics manager at retail chain Target. He has made $12 million in the last five years by simply shorting volatility.

But it's not just these kinds of stories. 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.

This is by far the biggest bubble in the market...

The biggest problem with this particular bubble is that these bets are all pro-cyclical. Folks in these positions can't hold them through a rough patch in the market. Instead, as the market falls, these investors must sell immediately. They are highly leveraged to the market.

Remember in May, when the S&P 500 Index fell just 1.8% over a few days? Volatility jumped almost 50% in that same period. One of the exchange-traded funds (ETFs) that investors are using to short volatility contains an interesting clause that few investors seem to have noticed: If volatility jumps more than 80%, the fund will liquidate with a net asset value of zero.

In other words, one day – who knows when – this fund, which holds billions in assets, will simply cease to exist. Investors won't lose a lot... They will lose everything.

Normally, that wouldn't worry me (or anyone else) too much...

What's different now is the size of the bets on volatility. This part of the market used to be only available to futures traders – generally large institutions. But beginning in 2011, 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 kind 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.

One final thought...

Until 2003, it was impossible to trade futures contracts on the VIX. The CBOE eventually agreed to tweak its formula to allow market makers to build a futures contract that could be traded.

You'll never guess which investment bank pushed for these changes – Goldman Sachs, of course. Goldman also designed the new contract. This contract exists so that in periods of extreme selling pressure, Goldman can execute the kind of trade that Brosens had to set up with individual insurance companies.

If you're thinking about buying an inverse-volatility ETF, ask yourself this: Who would you rather be... an insurance company, or Frank Brosens?

New 52-week highs (as of 10/12/17): Allianz (AZSEY), Boeing (BA), Biogen (BIIB), Bristol-Myers Squibb (BMY), Morgan Stanley China A Share Fund (CAF), CBRE Group (CBG), iShares Select Dividend Fund (DVY), iShares MSCI South Korea Capped Fund (EWY), Barclays ETN+ FI Enhanced Europe 50 Fund (FEEU), iShares U.S. Aerospace and Defense Fund (ITA), iShares Transportation Average Fund (IYT), Johnson & Johnson (JNJ), Lockheed Martin (LMT), McDonald's (MCD), Microsoft (MSFT), Nvidia (NVDA), Seabridge Gold (SA), Stanley Black & Decker (SWK), and Wal-Mart (WMT).

In the mailbag, a longtime subscriber is getting worried about the "Melt Up." What's on your mind? Let us know at feedback@stansberryresearch.com.

"Porter, can't you see what's happening? So now you are reluctantly on board with the Melt Up. Many others too. Saying stocks are expensive but get on board any way because everyone else is. Short hedge funds have been throwing in the towel. These and short ETF's providing much of the short covering that's been the source for this market. And buybacks. Only to make the weak earnings look better. This is becoming a very one sided trade. It's called capitulation. Odds are steep the buyers will dry up. This is exactly the thing you and Sjug warn about all the time. So you are on board the Melt Up. Et tu Porter?" – Paid-up subscriber Allen Whitmore

Porter comment: Obviously, I share your concerns, Allen. There's no question we're in a massive credit bubble. And as I've detailed in today's Digest, the HUGE risks to this market could materialize quickly.

But as investors, we face two risks... not just one.

The biggest concern we have is the permanent loss of capital. The other risk is just as real... It's the temporary loss of opportunity. To be a great investor, you must earn double-digit returns almost every year. The market is still offering good opportunities, and we have to take advantage of them, while trying to minimize the risk we face.

I'm striking the best balance I can. Our portfolio is hedged. We have about 10% in cash... We have some short positions... We have about 40% invested in fixed-income and fixed-income-like positions (insurance companies). Thus, about half of our investments shouldn't be highly correlated.

That's a long way from the kind of allocation you'll find in Steve's Melt Up Millionaire portfolio. This kind of allocation should allow us to keep pace with the market as a whole, while giving us far more protection in the event of a correction.

Regards,

Porter Stansberry
Baltimore, Maryland
October 13, 2017