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… So today, we want to kick things off with a special essay from Porter that was originally published on September 9, 2016.
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From Porter Stansberry, founder, Stansberry Research: We need to talk about true financial madness.
It’s something you don’t see very often. It can lead to the most incredible gains of your investing life. Or it can destroy all of your wealth if you’re swept up in it.
I’ve only seen two bona fide investment manias. I’m not talking about bubbles… or just overvalued securities. I’m talking about real “one way” trades—situations that can only lead to disaster. Yet for some reason, everyone comes to see the trade as a sure way to make money, not lose it.
Let me introduce the idea with a true story. It’s about John Templeton.
You might have heard of him before. He was very active in the markets for more than 50 years—between the Great Depression and the early 1990s. He built a huge mutual fund company, Templeton Investments, which he sold in 1992 and made $440 million.
His first “big trade” came right after Hitler invaded Poland in 1939. Stocks sold off, hard. There were 104 different stocks on the New York Stock Exchange that were trading for $1 or less. He put $100 into each of them.
His rationale was that during the Depression there was a surplus of everything, and therefore no profits. During a war, which was surely coming, there would be a shortage of everything and big profits. Within three years he’d made a profit on all but four of the stocks. Over a decade, the profits on this trade were more than 10,000%.
But that’s not the Templeton “big trade” that I want to discuss…
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The first real financial mania I saw was in late 1999 and early 2000. Technology stocks had been on a tear higher since the mid-2000s, with companies like Intel, Microsoft, Yahoo, and Qualcomm earning huge returns for investors. Later, though, the number and quality of the companies reaching the public markets began to decline substantially. And by January of 2000, the situation reached a peak. Garbage was being sold in IPOs to investors desperate to buy them. And so, en masse, investors began to believe a lie that couldn’t possibly be true.
It was the greatest financial mania the world had seen since John Law’s South Sea Bubble in the early 1700s.
I’m happy to report that we did a good job warning people about what was really happening…
As Steve Sjuggerud wrote in January 2000 (on the newsletter’s front page):
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We are at the peak of most likely the greatest financial mania that will ever be seen in our lifetimes… and quite possibly the greatest ever witnessed. |
With this warning, trailing stop losses, and basic securities analysis, we were able to avoid virtually all of the big losses during 2000 and 2001.
If you were in the markets back then, you surely remember a few of the most famous disasters—Pets.com, Webvan, and WorldCom. These firms were backed by respected venture capitalists and had business plans that were at least plausible. But this wasn’t just a bubble. It was a mania. Even the most obviously worthless ventures reached multibillion-dollar valuations.
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Inktomi, for example, reached a $25 billion valuation in March 2000. It made generic software for internet service providers, but never made a profit. In 2002, Yahoo purchased the company for $235 million. It overpaid. In 2009, the Inktomi software was donated to the public under an open-source license. Everyone can use it today for free.
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Boo.com spent $188 million of investors’ money and was worth more than $1 billion (on paper). It owned a single high-fashion online store and generated less than $10 million in revenue before going bankrupt in less than 12 months.
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Pixelon was a digital-streaming company that launched operations with a $16 million party, featuring The Who and the Dixie Chicks. It failed in less than a year. It never produced any revenue.
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And Lycos was a fourth-rate search engine. Spanish telecom operator Telefonica bought it for $12.5 billion. In 2004, it sold it for $95 million. It’s still around, believe it or not. Its owners promise that “new Lycos” is coming soon. It’s traded in India, if you’re interested.
There were hundreds of IPOs like these. An index of dot-com companies tracked by TheStreet.com fell 75% in 2000. Many stocks fell by 99%—including U.S. Interactive, Pacific Gateway Exchange, Cornerstone Internet Solutions, and Worldwide Exceed Group.
We read the prospectuses of many of these IPOs and laughed about how anyone would buy them at any price. Most of the disclosures said clearly that these companies had few, if any, clients. Most of them said they had no written agreements or contracts.
The risk disclosures explained, in plain English, that these weren’t real businesses and they had close to zero chance of staying in business. And it didn’t matter. No matter what was disclosed, investors would buy the stock. It was a true mania.
Templeton watched the market action quietly from his retirement home in the Bahamas. Finally, on January 1, he knew that the mania couldn’t go on much longer. The frauds were outnumbering the legitimate IPOs by 10 to 1. He called his broker in New York and gave very simple instructions:
Short as many shares as you can get of every technology IPO that lists. Establish the position 11 trading days before the lock-up expires. (The lock-up prevents insiders from selling shares until some period after the IPO, typically 90 days.)
In the first half of 2000, Templeton ended up shorting 84 stocks, putting an average of $2.2 million into each of them. He made more than $100 million on the trade, in about a year. More than half of the stocks fell 95% or more. Of the trade, Templeton told Forbes magazine:
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This is the only time in my 88 years when I saw technology stocks go to 100 times earnings; or, when there were no earnings, 20 times sales. It was insane, and I took advantage of the temporary insanity. |
I never thought I’d see a mania like that happen again in my life.
Remember… this wasn’t merely a case of overvalued stocks. This was a situation where investors were completely ignoring the obvious fact that the overwhelming majority of these companies would fail and then bidding them up to completely insane prices.
This wasn’t overexuberance. It was madness. And over the next 24 months, investors saw $5 trillion of market value disappear.
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But today, there’s a much, much larger and more dangerous mania. It’s a mania that has been created (and is being sustained) by central banks and printing presses. Today, around the world, something around $15 trillion in fixed income is trading at a price that guarantees investors will lose money if they buy the bond and hold it until maturity.
I want to make sure you understand what’s happening because the bond market and bonds are a mystery to a lot of individual investors.
A bond can trade at a negative yield to maturity (guaranteeing a future loss) while still paying a current coupon. How can that happen? It happens when investors bid the current price of a bond so far above par that the remaining coupons to be paid won’t cover the loss when the bond matures.
So for example, you might see a bond trading at $130, when it only has $29 worth of interest left to be paid before it matures at $100. An investor buying a bond like this has to believe he’ll be able to sell it at an even higher price, to an even bigger fool… or else he’s guaranteed to lose money.
Of course, all investors believe that they will be nimble enough to sell before that happens. And all investors believe that the government will continue to buy these bonds… or maybe even stocks… and do whatever it takes to keep the bubble growing.
This situation is the definition of an investment mania. Everyone knows that, someday, these bonds will reach maturity. And, at some point before they do, just as surely as the sun rises, these bonds are going to cause huge losses. And yet, despite these obvious facts… investors have begun to price even “junk” bonds—that is, noninvestment-grade debt—at prices that guarantee investors will take losses.
Just like Templeton back in 2000, I know for certain that this mania is running out of steam. How can I know for sure?
There are three big “tells”:
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First, total U.S. corporate debt is now 45% of GDP. That’s where the two previous credit cycles peaked (’02 and ’08). It’s simply not possible that the amount of credit outstanding to corporations can grow much from here because, even at very low rates of interest, there are not enough willing borrowers. Think about yourself. Does it really matter if someone offers you a 2% rate on a credit card? Are you going to go into debt for any reason? Nope.
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Second, and far more important when it comes to timing, the number of banks in the U.S. that are tightening lending standards is rising and has just passed a critical threshold (10%). Banks tend to tighten lending standards at the same time, at the end of a credit cycle and beginning of a default cycle.
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Third, we know for sure that a new default cycle has begun because not only are banks tightening, but credit downgrades (by the ratings agencies) have bottomed (in 2014) and continue to grow substantially. Likewise, outright default rates have bottomed and continue to grow rapidly. Morgan Stanley’s top high-yield bond analyst (Meghan Robson) believes the default rate in high yield will hit 14% by the end of 2017 (it was basically zero in 2014). She also says the total default rate will peak at 25% annually within five years.
The “fuel” that’s behind this mania and the reason it continues to grow (for now) is the fact that most professional investors, aka “Wall Street,” believe that without higher interest rates, there simply won’t be a trigger for a panic. But these guys are forgetting something that’s very, very important…
There are two ways to trigger a panic in the bond markets, not just one.
Yes, the first trigger is higher interest rates. (If new bonds are being issued that pay higher rates of interest, it makes the older bonds—which pay lower coupons—worth less in comparison.)
But the second trigger for panic, the one they’re forgetting, is simply rising defaults. Cheaper credit, by itself, won’t fix a failing business. Cheaper credit, by itself, can’t fix falling profit margins where there’s tremendous overcapacity, as there is in energy, manufacturing, retail, real estate, etc. In these sectors, defaults can and surely will cause massive losses for bond investors.
This panic will begin in the next 12 months. And because the numbers are so large and global, the coming bear market in junk bonds will influence fixed-income markets and equity markets around the world.
Since 2012, junk-bond issuance has totaled $1.4 trillion in the U.S. alone. That’s as much capital in four years as was issued in the decade between 2002 and 2012.
And for the first time ever, global junk-bond issuance has equaled America’s. It is this cheap and seemingly endless supply of capital that has lowered profit margins, which is why corporate earnings continue to decrease (four quarters in a row…) and industrial production is falling. It explains the glut in energy and materials, too.
I’ve been warning about this coming massive bear market in corporate debt. I’ve called it “the greatest legal transfer of wealth in history.”
This is a period when wise investors (like Templeton) will take massive amounts of wealth from fools. To help position you on the right side of this trend, I’ve invested a lot of time and money in building a huge analytical engine to study every corporate bond that trades in the U.S. We examine around 40,000 individual bonds every month. We build our own credit ratings for every issuer and we compare our estimate of creditworthiness to the ratings agencies. We look at discrepancies between our view, the ratings agencies’ views, and the market’s pricing. In short, we’re using computers and databases to find the “needle in the haystack.”
This analysis has, so far, led to 11 recommendations in our Stansberry’s Credit Opportunities service. Three of those recommendations never traded below our buy-up-to prices. Even so, the eight recommendations that have traded inside our buy-up-to windows (so far) have led to annualized returns of nearly 50%—with zero losses. The yield of this recommended portfolio is 7.5%.
Huge amounts of capital have flooded into the junk-bond markets this year, making it virtually impossible to buy bonds at a proper discount. But we know… our real opportunity is coming.
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But what about regular investors? What about folks without the capital or the sophistication or the patience to deal in the bond market, where getting a position filled can take months and dozens of phone calls? And… why only trade this mania from the long side? Why bother with finding the needles in the haystack? Why not simply do what Templeton did and sell short the bonds you know will fail?
That’s a great question. And I’ve spent a year thinking about the right and safe way to make gains that are big enough to cover the risks involved. The answer isn’t trying to short individual bonds. Or even bond exchange-traded funds. The right way is a wholly different kind of strategy.
Reeves’ Note: The strategy Porter’s using to take advantage of the madness in the bond market is something he’s never recommended before. Like Templeton’s strategy, it’s extremely contrarian… and will take a year or more to reach a substantial profit.
Now, this strategy requires discipline and patience—so most investors won’t follow it. And that’s the primary reason Porter believes it will work. He’s hosting a webinar on November 16 to explain exactly how his strategy works. You can preregister for the webinar for free right here…
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It’s time again for PBRG’s annual Infinity Conference (November 10-11). It’s our yearly wealth-building conclave. Mark, Teeka, Tom, and the entire PBRG crew will be in attendance… along with our “partners” in our business… This year, we’re adding a new feature to the conference… Research analyst Sean MacIntyre will be doing live, “boots on the ground” reporting from the conference. And everyone will have access to some of his “behind the scenes” clips from our most exclusive event of the year. Just “Like” the Infinity Conference 2016 Facebook page… and get free access to Sean’s Infinity coverage. |