Today’s stock investors take a couple of things for granted:
- Stocks always go up to new highs after falling in a bear market.
- That today’s current dividends being paid by companies will always continue.
But, at major market lows both of today’s “easy to make” assumptions will not only be challenged but will be ridiculed (dividends can be cut and some popular companies never recover US Steel, Xerox, GM, Enron, Cicso, AOL, Lehman, AIG, etc.). It’ll be much tougher to rely on these bullish arguments when they’re needed most – at the bottom of the next bear market.
We happen to think that stocks are almost as overvalued as they’ve ever been, with the exceptions of the 1929 peak and the 2000 one. Recall that in both of those instances the most popular averages fell close to 80%. To make matters worse, at those major peaks what was to come was virtually impossible to fathom – a Great Depression and Second World War, and the tech bust, 9/11 and wars that followed.
Below, we’ll cover some little thought of potential risks that are much more likely to garner headlines before the next bear is complete.
- The Junk Bond Bubble – Today’s investors (individuals, pension funds and insurance companies) get very little income in money markets, CDs, Treasuries or high grade corporates. As a result, they’ve been willing to fund any number of high credit risk companies by putting money in junk bonds disguised as “income” funds. The chart below shows the amount of high-yield junk debt that has been issued over the past several years. Note that 2012’s issuance was more than double the prior peak extreme in 2007. Also keep in mind that the “subprime” bubble defaults were about $400B. The Junk Bond Bubble is much, much bigger (chart courtesy of highyieldbond.com). The vast majority of this debt isn’t designed to be self-liquidating – it’s designed to be refinanced before maturity. The problem is, just like with subprime mortgage resets, when people become unwilling to loan money in a recession, viable companies will issue equity to pay the loans back, and the un-viable will simply default.
- The Coming Student Debt Write-off – Potentially even more troubling is the state of the student debt market. There’s now approximately $1.1T in student debt, with about $250B in default status. Also remember, that unlike subprime mortgages or even junk bonds, student loan debt is totally unsecured (meaning there’s no underlying collateral to liquidate). Student loan debt is now larger than mortgage debt was at the peak of that bubble. With populist politicians like Bernie Sanders gaining favor, expect a Federal “debt forgiveness” program to add to the national debt. Such a program was recently enacted after the bankruptcy of Corinthian Colleges. Imagine the outcry, “You can bail out the banks, but not the kids!” Some type of bailout (0% rates, stretching maturities, and debt forgiveness) is highly likely.
- Someone Decides to End QE – It should be obvious by now that Zero Percent Interest Rates (ZIRP) and Quantitative Easing (QE) don’t improve economies. How could they? They merely peg an artificially low interest rate which diminishes interest paid, but also interest earned. Both ZIRP and QE are only designed to benefit one set of people versus another (debtors benefit while savers/lenders don’t). Yes, you can make the case that both policies have pushed asset markets higher, and bought some time for people to reorganize their debts, but sadly this time has mostly been wasted. And it also has given companies, governments and people time to borrow even more money on the false belief that the financial crisis is now a distant memory.
But, if a country somewhere decides to abandon the idea of ZIRP and QE, or external pressure is put on a central bank to cease its involvement (like Rand Paul for instance), recognize that the immediate pain might be enough to push the global economy into a tailspin. After all, a heroin addict that quits cold turkey must go through the pain of withdrawal prior to coming out healthy on the other side. Just because we think QE and ZIRP should be abandoned, don’t mistake that for thinking the process of getting back onto sound monetary footing will be anything short of traumatic. A major recession is going to happen – the only question is whether it happens sooner and is smaller, or happens later and results in total destruction of the current monetary order.
Now, some will paint this as “doom and gloom.” Actually, it’s not. It is doom and gloom for the economy, but a major recession and returning to a sustainable economy will actually be uplifting for many. Rather than striving in meaningless careers in an attempt to attain the unattainable (satisfaction through material possessions), people will return to a more experiential existence, where happiness is actually achieved through family, friends and, oddly, the manual labor of producing necessities.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.