It’s here – the “Melt Up” we’ve been expecting…
During every pullback this year, I’ve reminded our readers that great bull markets like this one don’t end with a whimper, but with a roar.
Why do I believe that’s likely… yet also believe that a severe bear market is ahead, too?
Because the same economic forces that are propelling our stock market and economy higher and higher will eventually lead us into a spectacular bust.
I will explain those factors today.
And I’ll suggest a strategy that will allow you to ride the bull for as long as it lasts, while staying ready to protect yourself when the inevitable comes…
Earlier this year, as the market was hitting lows and approaching a 10% decline, a lot of our subscribers thought we were nuts for being long stocks in many of our publications, and for believing that the Melt Up was coming.
Since that bottom, many of our recommendations have soared. But what’s driving these gains and our economy forward?
My answer probably won’t surprise you…
We’ve seen some rocky days in the market lately. But I still expect a Melt Up from here, with the market (and our economy) continuing to grow at an incredible pace. Why? Because two things are happening right now that all but ensure this outcome…
The first is the raw fuel of hypergrowth: the creation of massive amounts of debt. Since our last big debt collapse in 2008, outstanding corporate debt has gone bananas. It’s up 40% in total, by more than $2.5 trillion.
Corporate-debt totals are now the largest they’ve ever been relative to gross domestic product. Excluding a handful of well-capitalized tech and pharmaceutical firms, they’re also near the largest they’ve ever been relative to corporate cash levels. Corporate America has “levered up” like never before.
And what else is at record levels? Share buybacks. Total share buybacks will almost certainly surpass $1 trillion this year, a level that far exceeds any previous annual amount. It’s more fuel for this long bull market as companies keep buying up shares en masse…
But to return to the subject of corporate debt: Sure, we know it has grown since 2008. But beyond the total figures, we also know corporate debt has reached excessive amounts…
We know this because a record amount of investment-grade debt is set to be downgraded.
I’ve long warned that huge growth in BBB-rated corporate bonds (one notch above noninvestment-grade, or “junk” bonds) would eventually cause a huge problem for investors… But the latest numbers are simply astounding… unbelievable… unprecedented.
Since the European Central Bank began buying huge amounts of corporate bonds just two years ago, the number of BBB-rated bonds in the core bond indexes has soared. It’s now more than double the number of all other rated bonds combined.
These indexes are built to mirror the market, meaning the character of the market has experienced a profound change, with a huge skew in issuance toward the lowest-quality bonds.
To summarize for non-bond-geeks: Investment-grade doesn’t mean what it used to mean.
Think back to the last big financial boom…
Back then, the primary driver of credit excess was Wall Street’s seemingly magical ability to transfer “toxic waste” – aka adjustable-rate subprime mortgages – into AAA-rated bonds.
Well, the big trick in this credit bubble is the central banks’ intervention into the corporate-bond market, which has transformed corporate junk bonds into “just barely” investment-grade bond indexes that essentially trade at par with sovereign bonds.
Presto: A booming global economy and stock market, along with enormous speculative bubbles like bitcoin and pot stocks.
I’ll give you three guesses as to what will happen next…
In the Wall Street Journal, James Mackintosh, editor of the Streetwise column, recently cited a Citigroup report that warned explicitly about the huge volume of corporate credits that the credit-ratings agencies will soon downgrade…
Hans Lorenzen, credit strategist at Citigroup, calculates that just the weakest BBB-rated bonds with a negative outlook or on review for downgrade, plus those where the issuer has other junk-rated bonds, amount to half the existing size of the $1 trillion U.S. junk bond market. In Europe, those close to the edge [of a downgrade to junk status] would add about 35% to the $405 billion junk market if all were downgraded.
The volume of these downgrades cannot possibly be absorbed into the high-yield (“junk”) bond markets without a serious jump in interest rates. And a rate spike would cause a huge decrease in available credit… just as trillions of dollars’ worth of corporate debts must be rolled over between 2019 and 2020.
It’s going to be a horror show.
Non-bond-geeks can think of these inevitable downgrades like Cinderella as the clock strikes midnight…
These aren’t actually investment-grade bonds. They’ve just been priced that way, thanks to the central banks’ endless spending. Alas, if only we could print prosperity.
What we’ve printed instead is the biggest financial bubble of all time. Of course, just as the fairy godmother’s magic couldn’t last past midnight, the central banks’ absurd foray into the corporate-bond market won’t last forever. Sooner or later, these companies’ declining financials will expose them for what they are: junk bonds. These lovely Cinderellas will suddenly look like redheaded stepsisters.
That won’t be a good day to own stocks.
But until then, the trillions of dollars in new corporate debt will power huge increases to share buybacks, which will convince the public that stock prices can only go higher.
That is what’s setting the stage for the Melt Up.
In the meantime, we’ll see plenty of warning signs before the clock strikes “midnight.” The three most important indicators to watch are…
- The prices of junk bonds. As credit tightens, the prices of junk bonds will fall. You can watch junk-bond funds – like the iShares iBoxx High Yield Corporate Bond Fund (HYG) – to monitor these prices.
- The interest-rate “spread” between high-yield debt and U.S. Treasury securities. As defaults grow, the increased risk will be expressed in much higher interest rates for weak borrowers.
- The 10-year U.S. Treasury yield. If safe yields on government bonds reach 4% or more, the corporate-bond market will experience complete carnage. Average rates to refinance outstanding debts will probably double.
So what’s happened with these indicators lately?
Junk-bond prices have declined off the recent highs in late September, yet they have bounced back above the July low…
Meanwhile, the interest-rate spread between junk bonds and U.S. Treasury bonds is virtually unchanged this year…
Even with the recent upward tick, it remains below the July high and near record lows – meaning that credit has almost never been cheaper or easier to obtain for noninvestment-grade corporate borrowers. (For non-bond-geeks: The money spigots are still wide open.)
And interest rates are still low. The yield on 10-year U.S. Treasury bonds (the single most important interest rate in the world) has risen slowly. It remains around 3.1%, or about the same level it reached in May.
I don’t believe rates at these levels will cause any problems. As I said, if the yield moves above 4%, that’s reason to worry. For now, we’re aren’t trading anywhere near these levels. And if rates move up slowly enough, the threshold for trouble will move higher.
In summary, it’s a gigantic, global credit bubble…
Enjoy it while it lasts. And, if history is any guide, the stock market will make some truly incredible moves higher before this party ends badly.
So watch your credit indicators. But stay long… And get ready for the Melt Up.
Source: Daily Wealth