You Probably Own These Ticking Time Bombs
Editor's note: If the market crashed tomorrow, do you think you could get out in time?
Many investors think they could. But it's a dangerous game... and not something we recommend leaving to chance.
This weekend's Masters Series is adapted from the June issue of Extreme Value. In it, Dan Ferris explains why risk happens fast... shows how some investors got blown up earlier this year... and explains why your portfolio is likely less safe than you realize...
You Probably Own These Ticking Time Bombs
Now and then, I hear from an investor who's gotten himself into a risky trade.
He'll usually say he knows he's taking a lot of risk, but that he'll be OK, because he'll exit at the first sign of trouble.
I always think the same thing: It'll go wrong fast – too fast for you to get out. Sell now.
Most individual investors don't understand the risk of fast ruin. They believe in the deep liquidity of markets because they've usually gotten into investing by opening an online brokerage account and trading big, liquid stocks like market darlings Facebook (FB), Amazon (AMZN), Netflix (NFLX), or Google parent Alphabet (GOOGL) – the so-called "FANGs."
The assumption of deep liquidity and easy exits can leave investors vulnerable to bigger, faster losses than they ever dreamed. That's why we often warned investors about situations where they're likely to suffer big, quick losses...
I started warning investors about higher volatility in the September 2016 Extreme Value, when we published Stansberry Research's most comprehensive report on the Chicago Board Options Exchange Volatility Index – the "VIX," also known as the market's "fear index." The VIX spiked 40% the day we published that issue. It closed that day at 17.50. Two months later, it traded at 22.51.
Over the next year or so, volatility drifted lower. I started getting concerned again and continued my warnings in the September 2017 Extreme Value, then reiterated them in my annual Stansberry Research conference presentation later that same month in Las Vegas, Nevada.
I highlighted the popular and highly risky trade of selling short the VIX through exchange-traded products and told conference attendees in no uncertain terms that these VIX short-sellers were going to get destroyed. I tried to make it clear that some trades have the potential to go wrong so fast, you'd never be able to exit before losing most of your investment. I told them the short VIX trade was one of them.
For a few months, volatility generally moved lower and the short VIX exchange-traded funds (ETFs) and exchange-traded notes (ETNs) moved higher. It made my warnings look just plain wrong. But I wasn't predicting when the volatility sellers would blow up. I was predicting that they'd blow up... And that it would happen so fast, investors wouldn't be able to exit before getting destroyed. I said it was like picking up nickels in front of a steamroller... except the steamroller has 16 gears and could shift from one to 16 in an instant.
So... how much would you invest in something that looks brilliant right up until the minute it ruins you and takes all your money? Human nature is so crazy that most people hear that question and start wondering right away how they might beat the odds and get out fast enough to keep most of their profits... rather than hearing the reality – the high probability they'd lose everything in minutes with no way to get out in time.
Unfortunately for many naïve investors, I was right. On February 5, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) fell 85% in minutes in after-hours trading. A couple of weeks later, it ceased trading altogether.
The ProShares Short VIX Short-Term Futures Fund (SVXY) experienced the same type of rapid decline, but still trades today... about 90% below its 52-week high.
The VIX rose 300% from its trough in January to its peak in February. It has since fallen more than 60%.
In a stunning testament to how short financial memory can be, Investor's Business Daily recently reported that hedge funds hold the largest short-VIX futures position since late January, right before global equity markets lost $5 trillion in value in less than two weeks.
Shorting the VIX is as lousy an idea as it ever has been. The likely outcome for many is instant ruin, just like before. Like I said in September, these folks will get destroyed.
I believe the era of persistently low volatility is over. Equity valuations are near all-time highs. Stock prices will likely be very volatile until stocks fall back into a more reasonable valuation territory, somewhere down around one times sales for the S&P 500 Index. That would be a pullback of more than 50% off today's levels.
"The short VIX trade seems like a speculative gamble," you're thinking to yourself. "Of course such a thing can go wrong in a heartbeat."
That's true, but few people thought that before it blew up. The VIX short sellers thought they had a sure thing. They were totally naïve about the potential for instant ruin. And they aren't the only investors like that...
Volatility selling isn't the only thing that can go wrong so fast it'll wreck you before you can sell. In fact, instant disaster can strike where you'd least expect it... in the bond market.
Back in September, I noted that the bond market was at its most expensive levels in history. I called it "the biggest bubble in the world." And right now, that bubble is bursting.
Take a look at the following chart. It shows the bonds of bankrupt toy retailer Toys "R" Us, which fell an astounding 72% in a single day last September...
One day in bonds is like one minute in stocks. You simply can't trade in and out of them as quickly as you can with most stocks. In Toys "R" Us' case, bondholders probably couldn't sell at all. Today, the bonds trade roughly 90% below their pre-bankruptcy levels.
The bond market is considered the "smart money." But it was clueless about the Toys "R" Us bankruptcy, and bondholders got wiped out in an instant.
Toys "R" Us bondholders aren't the only ones to get destroyed lately. The same thing has happened with varying outcomes to folks who owned the bonds of Japanese industrial giant Kobe Steel and South African retailer Steinhoff International.
Kobe's bonds fell last October when news surfaced that the company had fabricated data sold to top customers like Boeing (BA) and Toyota Motor (TM). Recently, we learned that this subterfuge appears to have gone on for decades.
The company's bonds have since recovered, but the rapid decline happened because somebody panicked and dumped them fast. It turns out that those who couldn't get out fast were lucky... The company's market cap fell from $4.4 billion to $2.6 billion in four trading sessions last October.
Meanwhile, Steinhoff's debt lost 50% of its value in a single day last December. The company reported accounting irregularities. Of note, it said that a portion of its former €3 billion cash pile didn't actually exist.
A similar scandal occurred at Italian dairy provider Parmalat in the late 1990s, when Bank of America (BAC) released a document showing that a bank balance of nearly €4 billion had been forged. Whenever people say "you can't fake cash," I ask them if they've heard of Parmalat. Now I'll have to ask them about Steinhoff, too.
Steinhoff's market cap was $23.5 billion a year ago. It fell to $14.9 billion, and then to $2.9 billion on December 7. The company's bonds haven't recovered like Kobe's have. Recent reports indicate Steinhoff's credit insurer has withdrawn coverage.
Perhaps you think these are obscure examples, despite once having a combined market cap of nearly $30 billion.
Would you call Italy obscure? The world's ninth-largest economy has a GDP of roughly $1.8 trillion. Its government has outstanding debt of about $2.3 trillion. Sovereign debt of major economies is supposed to be a safe investment. With that much outstanding, a tiny move in its bond prices will send shockwaves through the market.
Italian bondholders recently woke up to an instant jolt as the bonds fell about 2%, an enormous move for one of the world's largest sovereign debt issuers...
You can practically smell the complacency as Italian bond prices drifted along above par last year, then fell 5% in four trading sessions in May. The two-year bonds were issued in April 2017 and had never traded below 99 until that week.
Billionaire fund manager Bill Gross, aka "the Bond King," saw his $2.1 billion Janus Henderson Global Unconstrained Bond Fund drop about 3% in a single session in June – a huge one-day move for a bond fund – due to fears that Italy would have to leave the European Union (EU). If the Bond King can get whacked 3% in one day buying sovereign credits, what chance do peasants like you and I have?
Dozens of large, publicly traded bond funds look just like this chart of Italy bonds, down 5% to 10% over a period of days, weeks, or months. The $13 billion iShares 1-3 Year Treasury Bond Fund (SHY) lost $1 billion in assets in a single day this June. A short-term junk-bond fund, the iShares 0-5 Year High Yield Corporate Bond Fund (SHYG), lost $1 billion – about 27% of its total assets – in just a few days earlier this year...
Who can dump $1 billion in bonds that fast? Not you or me. It's likely a major institutional investor that doesn't want to get trapped in a giant bond position now that the bond bubble is beginning to pop.
With various debt instruments scaring investors away – including that of a major sovereign debt issuer – you have to wonder how long it'll be until equity market investors begin to feel spooked, too.
Good investing,
Dan Ferris
Editor's note: Of course, not all equities are ticking time bombs... And Dan recently found a stock that he says could become the first 20-bagger in Stansberry Research history – turning every $5,000 investment into more than $104,750. Get the details here.