Saturday, April 19, 2014
For the first time in about three years, investors began to panic... a little.
Given the record-high level of margin debt, the absurd valuations of many tech stocks, and the near-record premium in high-yield corporate bonds, I would be shocked if the selling in stocks doesn't continue.
As I have said many times, I expect a major correction in stock prices this year, with many stocks falling by 50% (based on their earnings multiples). Most of the major indexes (the Nasdaq Composite, the S&P 500, and the Dow Jones Industrial Average) are only now reflecting this trend. But we saw what was happening earlier because of a special index we built.
We built our "S&A Black List Index" by combining the stock prices of companies on our "Black List." This index shows you the combined performance of the stocks whose total outstanding shares were worth more than $10 billion in market cap and trade for more than 10 times their annual sales at the end of March. We know from experience that it's difficult for huge businesses to earn high enough returns on capital to justify such a rich valuation.
Keep in mind, we don't recommend using our Black List as a source of short-selling ideas. These are merely companies whose share prices we believe are too expensive to be purchased safely. While we expect their stock prices to disappoint long-term investors... trying to short valuation (overpriced stocks of great companies) can be a terrible strategy. The market can remain bullish for far longer than anyone believes is likely.
In fact, these are exactly the stocks that a real bull market is likely to push higher... far higher than the average stock. These are the stocks that people love.
As such, the performance of these particular stocks is a great "bull market litmus test." As long as these stocks rallied – irrespective of their inflated valuations – it was a pretty good bet that the bull market would continue. Looking at the chart, you can see the massive bull market that developed from 2012 and through 2013. Likewise, you can see these stocks seemed to have "rolled over" in 2014...
If these stocks continue to fall, we'll likely see a major correction in stock prices across the broader market, too. The individual stocks in this index are: social-media firms Facebook, Twitter, LinkedIn, and TripAdvisor; credit-card companies Visa and MasterCard; biotech firms Biogen, Illumina, and Vertex; Chinese Internet companies Baidu and Qihoo 360; pharmaceutical firms Regeneron and Alexion; REITs Public Storage, Prologis, and Avalon Bay; electric-car maker Tesla; cloud-computing firm Workday; pipeline companies Spectra Energy, Cheniere Energy, and Western Gas; and real-estate firm American Realty.
Of course... these aren't the only overvalued or dangerous stocks on the market right now. At the start of the year, not a single Wall Street analyst had a "sell" rating on Internet retailer Amazon. As I noted in the January 10 Digest, the stock was grossly overpriced, trading for 20 times book value and 150 times earnings. There isn't an honest or responsible way to recommend buying a company this large at these huge multiples.
I gave the warnings I felt were appropriate. I've been doing much the same in regards to corporate bonds and the bubble that's forming in auto finance, too.
I've reproduced a few of my key warnings from earlier this year below. For accuracy I've only used direct quotes. These are the exact words I've written since the beginning of this year.
I want to urge you to read these warnings again. There's no such thing as teaching. You'll have to think about what I'm saying and why. I believe it's very likely that many of you (or perhaps most of you) have ignored my warnings about stock prices so far. After all, just about everyone else (including a few S&A analysts) has predicted that the stock boom would continue. Whether you agree with me or not, at the very least, you should understand the risks to owning stocks right now...
Friday, January 10: Nasdaq Composite Index: 4,174. Amazon.com: $400 a share. Black List Index: 269.
Friday, January 31: Nasdaq Composite Index: 4,103. Amazon: $360 a share. Black List Index: 283.
Friday, March 7: Nasdaq Composite Index: 4,336. Amazon: $370 a share. Black List Index: 317.
Friday, March 28: Nasdaq Composite Index: 4,155. Amazon: $340 a share. Black List Index: 289.
Friday, April 4: Nasdaq Composite Index: 4,127. Amazon: $323 a share. Black List Index: 279.
Friday, April 11 (the original date of this essay): Nasdaq Composite Index: 4,043. Amazon: $312 a share. Black List Index: 272.
I attended the Grant's Interest Rate Observer Conference earlier this month in New York. This is revered newsletter publisher Jim Grant's twice-annual meeting of Wall Street's most powerful investors. The keynote address came from Jonathan Gray – the head of Blackstone's immense global real estate business. Out of respect for Grant – who, without any doubt, is the best newsletter writer in the world today – I won't discuss the conference in detail until after he has written about it in his newsletter. What I can discuss (mostly because it involves data from Moody's) is the situation Martin Fridson warned about in high-yield corporate bonds.
Fridson is the "axe" on the corporate-bond market. He has studied it longer than anyone else. He knows everyone in the business. And he knows all of the issues. He believes that $1.6 trillion in corporate bonds will default over the next five years. That's roughly 30% of all the outstanding high-yield corporate debt. It's around 1,100 individual defaults. And it's equal to an annual default rate of 7%-8% – far, far below the peak annual default rate of 13%, which we saw in 2009. In short, Fridson's call, believe it or not, is conservative.
The problem we face in the high-yield corporate-bond market is that the mix of debt is at an all-time low in terms of rating. There is more very low-quality debt than ever before. During the last restructuring cycle (2009), the Federal Reserve intervened and bailed out just about everyone. That prevented the normal "cleansing" in the market and left a lot of dodgy corporate obligations outstanding.
The prices of bonds, however, don't reflect any of these risks. They were trading at yields below 5% last May and continue to trade below 6% today. Investors who buy high-yield corporate bonds at today's prices will get wiped out over the next two years.
Investors, motivated by the Federal Reserve's efforts to manipulate interest rates to nearly zero, have piled into "risk" assets – like growth stocks and high-yield corporate bonds. They largely ignored the risk of making these investments – buying stocks like Amazon and others at absurdly high prices and ignoring the historic default rates in bonds.
But despite the Fed's efforts... we don't believe that risk has been forever banned. Humans will make misjudgments. Investors, full of confidence today, will feel differently tomorrow. And just as surely as the sun rises and sets, the credit cycle will turn. Default rates will rise from 2% this year... to 6%-8% by 2016... and then to perhaps as high as 15% in 2017.
Anticipating these problems, equity markets will correct. No, this isn't the end of the world. I don't think any of the major indexes will crash down to their 2009 lows. But businesses – like many of the overpriced tech stocks without any earnings that depend on easy access to credit – will come crashing down. Stocks trading at stupid multiples will fall by 50%. Amazon, for example, is down about 20% since I first warned you about it. I bet it is only about halfway finished correcting.
What should you do?
If you're sitting on a large amount of cash, I wouldn't be eager to buy a lot of stocks or bonds right now. I'd wait for better prices. They're coming. If you're heavily long the stock market, I'd cut back... significantly.
If you have some experience as a trader, I'd recommend selectively shorting stocks. We keep a "victim's list" of stocks that are either obsolete, overly indebted, or frauds. Start with these. Hedging 10%-20% of your portfolio with short positions can really help reduce your portfolio's overall volatility and can even help you make a profit in a year where stocks fall 10%-20%.
In addition to our short positions, we are selectively adding some stocks to my Investment Advisory portfolio – specifically stocks that will weather a correction and prosper in its wake.
Eventually, the Federal Reserve will lose its ability to artificially boost our economy. And rising interest rates will further kill any chances of a true economic recovery and will destroy the middle class. As prices for goods and services are rising, their wages will be stagnant (or worse, falling)...
That's why we're adding exposure to companies that cater to these people – stores that sell the goods they absolutely need (regardless of what's going on in the economy) and the companies that produce them. We also recommended a company that rents affordable, single-family homes.
This widening wealth gap is a major trend... And we're well-positioned to profit as it unfolds. These are some of the most conservative, recession-proof businesses in the market. They're a mainstay in any portfolio moving forward.
You can access my research with a four-month, 100%-money-back guarantee. You'll gain immediate access to all my current recommendations, including this month's issue, which just hit inboxes last week. Learn more about a subscription to Stansberry's Investment Advisory by clicking here.
But... the most important thing for you to do is simply have a conservative mindset today. Follow your stops. This isn't the time to "be a hero." This is a time to begin raising cash. This is a time to flee risk. A real bottom in stocks is a long, long way from here. We need to see high-yield bonds trading at yields above 10%... or 15%... before we will be even close to that moment.
Date Range:4/10/2014 to 4/17/2014
Date Range:4/10/2014 to 4/17/2014