So, what am I concerned about heading into the rest of the year, and what will likely be the best investment for the rest of year…there is a lot to worry about.
- Rising trade tensions once again between the U.S. and China.
- Tariffs which impact corporate profitability and consumer spending.
- Higher interest rates on a debt-laden economy
- Weakening global economic growth
- Weakening corporate profitability and outlooks.
- Excessive market valuations.
The list goes on. But all of these issues are just the “fuel” waiting on the right catalyst.
What will that catalyst be? No one knows. I am not trite.
The issue that trips up the market and begins the sell-off process which balloons into a credit-related event is ALWAYS something the market is not aware of or focused on. It is the “surprise” of the event which shocks markets into major reversals.
What could it be? My best guess is probably something like a Deutsche Bank. It looks a lot like Lehman did back into 2007. The risks and warnings signs were all there; we just dismissed them under the guise of “this time is different.”
The biggest risk for us right now is simply the amount of “leverage loans” which has built up in the system over the last decade due to low-interest rates.
One of the common misconceptions in the market currently, is that the “subprime mortgage” issue was vastly larger than what we are talking about currently.
Not by a long shot.
Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors.
Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.
Of course, that didn’t end so well.
Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well.
As noted by John Mauldin:
“In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder. And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.”
As the Fed noted a downturn in the economy, signs of which we are already seeing, a significant correction in the stock market, or a rise in interest rates could quickly cause problems in the corporate bond market. The biggest risk currently is refinancing the debt. As Frank Holmes noted in a recent Forbes article, the outlook is rather grim.
“Through 2023, as much as $4.88 trillion of this debt is scheduled to mature. And because of higher rates, many companies are increasingly having difficulty making interest payments on their debt, which is growing faster than the U.S. economy, according to the Institute of International Finance (IIF).
“On top of that, the very fastest-growing type of debt is riskier BBB-rated bonds — just one step up from ‘junk.’ This is literally the junkiest corporate bond environment we’ve ever seen. Combine this with tighter monetary policy, and it could be a recipe for trouble in the coming months.”
Let that sink in for a minute.
Over the next 5-years, more than 50% of the debt is maturing.
As noted, a weaker economy, recession risk, falling asset prices, or rising rates could well lock many corporations out of refinancing their share of this $4.88 trillion debt. Defaults will move significantly higher, and much of this debt will be downgraded to junk.
The point here is there is more than sufficient “fuel” for a crisis akin to what we saw in 2008.
However, if you wait for it to occur, it will be too late to do anything about it.
But, this isn’t an issue that will likely come to play in 2019, given we are already halfway through the year.
For the rest of this year, we like CASH.
Let me explain.
Currently, investors have become extremely complacent with the rally from the beginning of the year and are quick extrapolating current gains through the end of 2019. As shown in the chart below this is a dangerous bet. In every given year there are drawdowns which have historically wiped out some, most, or all of the previous gains. While the market has ended the year, more often than not, the declines have often shaken out many an investor along the way.
Let’s take a look at what happened the last time the market started out the year up 13% in 2012.
From a portfolio management standpoint, the reality is that markets are very extended currently and a decline over the next couple of months is highly probable. While it is quite likely the year will end on a positive note, it is quite probable if you went to cash today, you probably won’t miss much between now and then..
Why cash?
1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash.
2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.
3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are highly correlated.
4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong as we have seen two declines of over -50%…just in the last 18-years. Keep in mind, it takes a +100% gain to recover a -50% decline.
5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again.
6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also simply transfers the “risk of being wrong” from one side of the ledge to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.
7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.”
8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms.
Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.
With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important.
Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.
Lance Roberts is Chief Strategist for RIA Advisors and Editor of Real Investment Advice