Editor’s Note: Longtime Daily readers will recognize PBRG friend Porter Stansberry as one of Tom’s mentors and one of Mark’s mentees. He’s also one of the most brilliant minds in the financial sphere—anywhere.
Porter says this is a critical moment for self-directed investors. And we want to make certain you’re prepared…
On Sunday, Porter described a “Big Trade” that he’s been looking into. Today, we continue on that theme with the first in a two-part essay series (originally published on September 30, 2016) that delves into the “Big Trade.”
 |
From Porter Stansberry, founder, Stansberry Research: Recently, I told you a little about what I believe is the biggest and most important opportunity I’ve ever seen in my entire 20-year career.
If you haven’t noticed, a historic mania has developed in the world’s bond markets. Central banks have pushed so much new money into bonds (in an effort to manipulate interest rates lower) that corporate bonds have begun trading with negative yields, meaning that corporations are now being paid to borrow.
This, as you might realize, makes absolutely no sense. Sooner or later, it’s going to cause catastrophic problems with the world economy—perhaps even the collapse of the entire financial system.
I hope you’ll print out today’s issue, read it carefully, and continue to monitor a few of the data points I’ll detail below. What I’ve written here is a guide to understanding how this incredible global mania will end… and when.
I’m also including a detailed description of what I’m calling the “Big Trade.” It’s a relatively simple way individual investors can create synthetic credit default swaps (CDS) on a few dozen of the world’s weakest corporate credits. Remember, CDS were the instruments that a few investors used to make billions of dollars when the mortgage bubble burst almost 10 years ago. And I think we’ll soon have another chance at those types of profits.
This morning, the European banking system moved one step closer to the brink…
One of Europe’s largest banks, Deutsche Bank, is teetering on disaster… And German Chancellor Angela Merkel has said the country won’t provide a bailout. Meanwhile, Deutsche’s CEO John Cryan is blaming “speculators”—not shoddy lending and a stagnant economy—for the bank’s woes. He’s trying to reassure the bank’s 100,000 employees that Deutsche remains strong, despite its clients rushing to withdraw funds.
Deutsche has roughly $2 trillion in assets. That’s almost 11% of U.S. GDP. By this metric, that’s slightly larger than U.S. banks Wells Fargo, which has $1.9 trillion in assets, and Citigroup, which has $1.8 trillion in assets.
But here’s the thing… Deutsche has a tangible common equity ratio of just 2.9%. That’s the bank’s tangible equity divided by its tangible assets. What this means is the bank can sustain losses of only 2.9% before its equity capital is wiped out. By comparison, Wells Fargo sits at 7.7%, while Citigroup shows 10.3%.
According to the International Monetary Fund, Deutsche is the riskiest financial institution in the world… the “most important net contributor to [global] systemic risks.” But the problems don’t stop with Deutsche. The likelihood of a “Lehman moment” in Europe gets closer each day.
The European Central Bank estimates that European banks hold bad loans totaling nearly 1 trillion euros—that’s the equivalent of 9% of euro-area gross domestic product (GDP). Italy’s Banca Monte dei Paschi di Siena, the oldest bank in the world, needs to raise 5 billion euros of equity (on top of the 8 billion it has raised in the past few years) and dump 28 billion euros of bad debt. The bank is also considering encouraging its bondholders to swap debt for equity—essentially admitting default. Its shares are down 85% this year. Italy’s UniCredit is also doomed… As are banks like Banco Popular Espanol SA.
We could soon see the equivalent of a 2008 crisis in Europe. Rest assured the financial problems coming to roost abroad will spark a global selloff in equities. Nothing will be spared (save gold and silver). You need to be prepared. Luckily, we’ve seen how this all plays out before. And we made handsome profits…
The last time I saw the markets with this kind of clarity was June 2008.
That’s when I penned what’s perhaps the most famous issue of my newsletter (or any newsletter). The headline gave it all away: “Fannie Mae and Freddie Mac Are Going to Zero.”
In that letter, I explained why the world’s two most important mortgage banks (Fannie and Freddie) were certain to fail. I showed why rising mortgage default rates would also cause at least Lehman Brothers, Citigroup, and Merrill Lynch to follow suit. And I warned that virtually the rest of the entire global financial system could follow. I didn’t mince words…
|
Fannie Mae and Freddie Mac, the two largest and most leveraged owners of U.S. mortgages, are sure to go bankrupt in the next 12 months… I recommend you sell an equal amount of each stock short. I have so much confidence in this trade I recommend you use a 25% stop loss, not a trailing stop loss, as the position could be volatile for the remainder of this year. And unlike most short sell positions that I recommend you buy to cover after you’re up 50%, I recommend you hold these positions until the shares literally no longer trade. |
About a month after I published my report, Hank Paulson, the U.S. Treasury Secretary, officially denied that Fannie and Freddie were in peril, claiming both firms were “adequately capitalized.” Rarely has a bigger lie ever been told—Paulson’s was a $5 trillion fib. The entire financial system imploded about 90 days later, wiping out even AAA-rated collateral, not to mention wiping out Fannie and Freddie. Remember: The government has always lied about every “financial crisis,” including what’s happening in Europe right now. And it’ll certainly lie about the next one, too.
Nine months after I warned Fannie and Freddie would fail, not a single leveraged U.S. financial institution would have survived without the explicit backing of the federal government. Trillions of dollars were ginned up in an alphabet soup of bailout plans. In about a year, the world had turned upside down, from the supreme confidence of the stock market’s highs in November 2007 to the biggest panic since at least the Great Depression.
It will happen again. Soon.
As I’ll detail below, we now have less than 12 months until rising default rates on corporate debt, along with a sharply slowing global economy, cause a new wave of panic in the financial markets. I’ve been warning about these trends since they first appeared in mid-2014. Longtime readers will be familiar with the themes and data I summarize below.
What’s new is that these trends are now accelerating and causing steep declines in earnings, production, and employment. I’ll get to these details, too. But first…
I want to talk about what you can do to position yourself to profit from these trends safely. I’m not talking about “betting the farm” that you can nail the timing of the next big market turn. I’m only talking about setting up a portion of your portfolio so that when the huge wave of corporate credit defaults hits, your portfolio will be well-protected—insured, if you will—against losses.
The real opportunity you have today isn’t just the clear trends that have emerged or the ridiculously large number of vastly overleveraged corporations. The real advantage we have today is that insurance against corporate defaults is cheaper than it has ever been before. The same trends that created the bubble in corporate bonds have also warped the market for equity options, driving the Volatility Index (“VIX”)—which reflects the price of options—to near all-time lows.
Even if I had been clever enough to recommend puts on Fannie and Freddie in June 2008, establishing that kind of position would have been extremely expensive. Following the Bear Stearns bailout of March 2008, the VIX remained elevated throughout the year. And by late 2008, the VIX was trading at historic highs above 80. (Today the VIX is around 12. The all-time low is around 10.)
This is very important to understand… our opportunity in my new “Big Trade” only exists because, so far, the obvious risks in the global bond market aren’t being priced into the options market.
This dichotomy—a huge bubble in bonds and historically low options prices creates our opportunity. It’s an even bigger opportunity than the one I saw in 2008.
Back in June 2008, the $5 trillion U.S. mortgage market blew up. Losses on mortgages, which reached almost a 10% annual default rate, sent shrapnel across the world’s financial system and nearly destroyed every leveraged financial-services firm in the developed world. But today, we face a much, much bigger problem.
U.S. corporate bonds outstanding are currently worth almost $8 trillion, roughly 45% of U.S. gross domestic product (GDP). These obligations include nearly $2 billion worth of junk bonds. Annual default rates of around 15% are typical for junk bonds at the peak of a credit-default cycle.
This cycle is likely to be far worse than average. Thanks to the government’s 2008/2009 intervention, we haven’t gone through a legitimate market-clearing cycle since 2002. Bond-market veterans are expecting something around $1.5 trillion in defaults through 2021—or about three times more in defaults than we saw in the mortgage crisis.
To see the coming end game clearly, you have to think about actions taken by the world’s central banks. Year after year, since the early 1980s, central banks have made capital cheaper and cheaper. That has sent the yield on benchmark debt (like the 10-year U.S. Treasury) to all time-lows. In many places around the world (Japan and Europe, for instance), capital isn’t merely cheap – it’s free or even paying a negative yield. That’s a world turned upside down.
But what’s the end game? How will all of these manipulations become unglued? How will this vast global shell game finally unravel?
The inevitable outcome of these policies is unprecedented amounts of global overcapacity. Why?
Well, just follow the money.
When credit is too cheap (or free… or better than free), vast amounts of new money will be borrowed. Look at the huge amounts of capital that have been invested over the last decade in discovering new oil resources—about $700 billion annually since 2006, or more than 10 times more than has ever been invested in any previous 10-year period. Can all of these projects succeed? Of course not. It was only a matter of time until increases to production and additional capacity caused prices to collapse and weaker producers to fail.
The same thing is now taking place across vast portions of the global economy—not just oil and gas. Super cheap (and even free) capital has caused massive distortions in capital spending around the world. Economists from the so-called Austrian school call these “malinvestments.” They’re made with “funny money,” not legitimate savings. These artificial booms don’t produce lasting prosperity. They’re merely a kind of inflation… and they’re always followed by a sharp collapse.
That’s what we’re about to see. It’s obvious that far too many capital projects have been started. Too much risk was taken in industries and countries all around the world. Now we see profit margins and earnings falling, because there’s far too much supply. We see defaults rising as weaker producers fail. And we see production stop growing and begin to decline. Employment will decline next… and then defaults will really begin to grow.
So… do we actually see these trends playing out around us? Yes, as I’ve been documenting for months in the Digest. Here’s a review…
Let’s start with commodity prices.
Look at the world’s commodity markets – oil, steel, shipping, agriculture, minerals, materials, etc. The prices of these commodities have been falling steadily for years.
To see the impact of the overcapacity across the entire commodity sector, study the Baltic Dry Index, which measures the price of shipping bulk commodities. It’s a great indicator of the basic supply-and-demand equilibrium for the entire commodity complex. The index hit an all-time low earlier this year and has only rebounded slightly because of dozens of bankruptcies among shipping firms and the resulting scrapping of ships. (Around 1,000 ships have been scrapped this year, about 7% of global capacity.) But there is likely more pain ahead… French bank Credit Agricole just warned this morning that it is preparing to set aside extra loss provisions on its $15 billion shipping portfolio this year.
Another obvious sign: The global oil cartel OPEC has just agreed to cut oil production, but the amount of oil being produced at America’s top fields continues to grow. America is now producing so much oil that the OPEC cuts will only result in about a 1% decrease in global supply.
But those are just the general signs of global overcapacity. There’s a growing body of evidence the U.S. economy is heading into a recession soon. We’ve written about these signs repeatedly over the last several months…
|
The longest-running and most troubling sign is the ongoing declines in U.S. industrial production. Declines in industrial production are among the most important and longest-running leading indicators of a recession. In August, U.S. industrial production had officially fallen by 1.1% for the year – it was the 12th consecutive month of contraction. In the last 100 years, we’ve never had a 12-month streak of continually declining industrial production that wasn’t followed by a recession. Ironically, back in April, the Wall Street Journal wrote that the declines in industrial production weren’t a problem for the economy because “This time should be different.” If those words don’t set off your alarm bells, nothing will. (The newspaper’s theory was that the U.S. economy is now driven by consumers, not producers. Yes, really. And guess what has been powering consumers? Credit, of course. But how long will that last? Can we truly consume our way to prosperity?) |
The U.S. transportation sector has been in decline since 2014, based on the Dow Jones Transportation Average. Transportation stocks have been a leading economic indicator for more than 100 years, as transportation reflects the growth (or decline) in orders for consumer and durable goods.
Based on forecast earnings, the S&P 500 will soon report its sixth consecutive quarterly decline in earnings. In August, the second-quarter reporting was completed, showing that the S&P 500 had seen five consecutive earnings declines for the first time since 2008/2009. Earnings are declining because profit margins have declined for eight quarters in a row, beginning in the second quarter of 2014.
With the index trading at 25 times last year’s earnings, a sustained decline in earnings will eventually trigger a rout in stock prices.
Excluding the massive tech-stock bubble in 2000, U.S. stocks have never been this expensive relative to earnings. And if you include corporate debt in these calculations (if you compare earnings with the entire enterprise value, not just the market cap), then you’ll see that U.S. stocks have never before been this expensive in history. Trust me when I tell you… this bubble won’t end any differently from the others. It isn’t different this time. It never is.
Of greatest concern to me is the overall level of corporate debt. Corporate debt in the U.S. has consistently topped out at a little less than 45% of GDP. Historically, the debt cycle has turned at that point. Defaults rise, issuance declines, and a bear market begins. Today, that level sits at 45.4%.
This summer, the default rate on U.S. junk bonds spiked up to 5.1% according to credit-ratings agency Moody’s, and is expected to hit 6.4% before the end of the year. Historically, default rates above 5% have signaled the beginning of a new credit-default cycle. That’s likely to be especially true this time, given that the default rate hit record lows in 2014 and has been steadily rising since.
Finally, as I mentioned earlier, there’s an ongoing European banking crisis that nobody seems to want to talk about. Shares of Deutsche Bank are now down more than 66% over the past two years. Italy’s largest bank, UniCredit, is down just as much. Same with the Royal Bank of Scotland, a leading British bank. Globally, it seems very unlikely that this credit cycle can continue to expand in the face of a serious banking crisis. Likewise, it seems unlikely to me that U.S. banks with lots of global exposure won’t eventually face the same headwinds.
Even if you haven’t really understood everything I’ve written above, I know you’ll understand this…
Governments around the world have brewed up the biggest economic hurricane in the history of capitalism. They’ve printed so much money that they’ve warped the entire global economy, financing absurd surpluses in markets all around the world. That is crushing profit margins, causing default rates to rise and production to fall.
Look at China’s debt expansion. Total private debt grew from $10 trillion to $30 trillion in just the last five years. And no surprise, you’ll find tens of thousands of empty apartment buildings all over China. You’ll also find huge stockpiles of raw materials.
Look at the United States’ $80 billion auto bailout. You’ll find record car sales, but falling earnings for the major carmakers. You’ll also find a startup (Tesla) that has never made any money and now has total debts of almost $7 billion. And investors believe the company is worth $30 billion!
[In tomorrow’s second part, Porter explains how to use the “Big Trade” strategy to hedge if you’re still fully invested, or as a speculation to make 20 times your money (or more) over the next 24 months.]
Reeves’ Note: Porter will be holding a webinar on November 16 to reveal the “Big Trade” from Stansberry’s studio headquarters in Baltimore, Maryland. You can register for this free event right here…