Porter Stansberry: My prediction for 2018

From Porter Stansberry in Stansberry Digest:

And so 2018 begins…

I (Porter Stansberry) believe that 2018 will be a truly historic year in the markets.

I think it’s likely that we’ll see a huge “blow off” top in equity prices… and then a big reversal. I’ll explain why in detail below. Whether you agree with me or not isn’t that important. What is important is that you understand some powerful underlying forces are moving the market right now. They will play a huge role this year.

I’m sharing these ideas with you because I think they’re important – especially this year. But quite honestly, these “macro” thoughts aren’t especially relevant to the decisions I make as an investor.

What?

In my experience, most investors dramatically “overweigh” the importance of macro forces and dramatically undervalue the skills, knowledge, and strategies that can actually deliver reliable (and safe) returns.

So… in addition to telling you what I think will happen in the markets as a whole this year (and why)… I’m also going to beg you to do three things that you’ve probably never done before…

These three strategies will make a much more powerful and lasting impact on your ability to increase your wealth than any of the macro ideas I could give you. And I’ll show you exactly why.

But no matter what I do… I’m almost certain two things will happen:

No 1. You’ll pay far too much attention to my macro forecast, especially if it matches your existing bias.

No 2. You’ll completely ignore the three things that I know every investor should do this year (and every year) to improve his investment performance.

So… why do I bother?

Well, it’s simple. By supporting Stansberry Research as a paying subscriber, you’ve given me and the almost 200 other people who work here the greatest job in the world. As Warren Buffett says, “I skip to work every day.” A special thanks needs to be given to our Stansberry Alliance members, who have joined our partnership with a large ($30,000) lifetime commitment to our efforts.

In return, I and the other equity partners and longtime employees at Stansberry Research have dedicated our lives to helping our subscribers make better investment decisions and achieve better investment results. For us this isn’t merely a job, it’s a round-the-clock passion that fills our lives with purpose and meaning.

If you’re new to Stansberry Research, I strongly suggest that you attend a conference, say hello to us in person, and judge our commitment to our subscribers for yourself.

As the chairman and founder of the company, one of my key responsibilities is to make sure that we continue to always put our subscribers first in everything we do, from new product development, to the type of people we hire, to the lines of business we decide to engage in.

That’s why I urge both our subscribers and our employees to always reach out to me immediately (feedback@stansberryresearch.com) if there’s ever a problem that might harm our subscribers. As longtime subscribers know, I read every feedback e-mail that we receive and take direct action whenever it’s required.

But… my primary job is to make sure that we continue to publish the information I’d want if our roles were reversed. That’s why I write the Friday Digests personally, as I have since we started our efforts back in 1999.

It’s in our Friday Digest that you’ll see me highlighting our reports and the ideas that I believe are the most important concepts for you to follow right now.

And what I’ve seen is that it takes a long time for most subscribers to begin to trust us enough to try to follow our most powerful strategies. It’s simply incredible how many mistakes most investors insist on making before they will begin to adopt the basic principles that Stansberry Research preaches… again… and again… and again…

So that’s how I’m starting out the year…

I’m reviewing three of the most important and fundamental investment strategies that we know will work, no matter what kind of market we see develop in 2018.

Whether you’ll come to trust and depend on our efforts and my sincerity, I can’t predict. But as my longtime business partner, Bill Bonner, taught me: “Porter, you can’t guarantee success. You can only deserve it.”

I’m going to get up every day this year, just like I have every day for the past 19 years, and do my very best to help you succeed in the financial markets. Thank you for giving me this opportunity.

Let’s start here… with what I believe will be the major factor driving the financial markets this year…

How quickly we forget…

It was less than 10 years ago, in the closing months of 2008, when our monetary masters – led by stuttering Ben Bernanke – began an enormous monetary experiment. The Federal Reserve started printing new money, out of thin air. These new dollars were used to buy financial assets – mostly newly issued federal bonds, but also mortgages of dubious quality. The result was a multiyear “one way” bet on interest rates that powered the earnings of banks, hedge funds, and traders. It also led to the largest increase in corporate and private debt ever and larger total debts than our economy had ever seen before.

The government, its private bank, and its pocket economists proved they could stop a debt crisis… by creating stupendous amounts of new debt. It was as though they’d worked a miracle.

Meanwhile, the balance sheet of the central bank in the U.S. grew from $800 billion to more than $4 trillion…

Again, this didn’t just happen in America. The central bank of Japan printed more than anyone else and ended up becoming the largest shareholder in virtually every Japanese business. The Swiss central bank ended up earning more in dividends, coupon payments, and currency appreciations than any other private business in the world, about $55 billion.

Meanwhile, like squirrels watching a bank robbery, none of the economists and precious few investors noticed anything important happening…

Nobody noticed any inflation (because they ignored the huge rise in financial asset prices). Nobody noticed the collapse in certain commodity prices (like oil) and the resulting bankruptcies, where far too much capital had been borrowed and lent.

But eventually… like the pressure rising in a kettle, turning to steam, and blowing out with a whistle… things started going a little haywire in the global economy. By late 2016, negative interest rates threatened to destroy the global banking system. Shares of Deutsche Bank, one of the world’s largest, dove down past $10, a critical threshold.

At the time, even junk bonds in Europe were trading with negative interest rates. European banks were paying mortgage holders to live in their houses, instead of the other way around. Commodity prices fell so far that it was cheaper for many American energy producers to burn off natural gas instead of pushing it down a pipeline. It was as though the financial world had been turned inside out and upside down. Stranger Things wasn’t just a TV show: It was our financial reality.

And then, what I believe was the final and ultimate warning sign of this big inflationary bubble – cryptocurrencies

In 2017, the bubble reached a whole new kind of level, something we hadn’t seen since the days of the South Sea Bubble. Digital “tokens” – backed by nothing, yielding nothing, and conveying nothing – began to soar in value, merely because they, unlike paper currency, couldn’t be manipulated by central bankers. By North Korean hackers? Maybe. But not central bankers.

The greatest monetary experiment in modern history is drawing toward a close…

The crytpo bubble must have finally been too much to ignore. Even squirrels could tell something was wrong with our money. And so… the tide has begun to head out.

Most investors don’t know anything about this… But the Fed is quietly reversing course. It’s draining the system of reserves. On October 1, the Fed began to allow its balance sheet to “run off” by $10 billion a month. That is, as the bonds it holds mature, it won’t “roll” the assets into new securities. And so, for the last three months, the Fed has seen its balance sheet shrink by $6 billion a month in U.S. Treasury securities and $4 billion a month in mortgage securities.

You can see for yourself what this is doing to the prices of short-term U.S. bonds. They’ve gone down in basically a straight line since the policy change was announced in September 2017.

The tide is rolling out…

It took the speculative bubble a long time to reach negative interest rates on junk bonds and $20,000 cryptocurrencies. It will likewise take a while (but not as long) for this fundamental change in the financial markets to hurt sentiment and securities prices. But make no mistake, the tide is going out. And the tide is going to get more powerful as it moves.

I don’t mean that rhetorically or as some kind of metaphysical prediction. I mean the size of the Fed’s reserve decreases will accelerate for all 2018. Specifically, the amount of securities the Fed will no longer roll forward will increase at $10 billion per month for all of 2018. Doing the math, that’s a $420 billion decrease in the size of the Fed’s balance sheet in one year. That’s a sizeable reduction in demand for both mortgages and U.S. Treasury securities.

And just as speculators enjoyed a one-way bet on the way up, they now have a one-way bet on the way down.

The link between the Fed’s purchases (and sales) of securities and the other markets isn’t direct…

The Fed’s actions will primarily impact interest rates (and bond prices) at the short end of the curve – that’s bonds and mortgages with durations of five years or less.

Far more important to equity prices and the sentiment of the bond market are the prices and yields on longer-duration mortgages and the 10-year U.S. Treasury bond. You can think of the yield of the 10-year Treasury bond as a kind of gas pedal for the price of global financial assets. The lower it goes, the more gas is being sent into financial markets. But as the pedal rises, those carburetors are getting less and less fuel… and the motor is going to slow.

As you can see in the chart below, the price of longer-term bonds is also now moving in the wrong direction in a pretty linear fashion.

Let me reiterate…

The resulting impact on financial markets won’t be immediate. It isn’t direct. But it is, like gravity, irresistible. The Fed’s actions and the resulting higher interest rates are going to eventually put a “pin” in the global financial bubble. The clock is ticking.

Let me give you one example of how this macro force impacts the real economy…

Most banks and all mortgage finance companies borrow money at a short-term rate, like two years. They then lend out this capital at the higher, long-term rate, like 10 years. As long as short-term capital costs less to borrow than long-term capital (and it should), then the banks and mortgage companies have a great, capital-efficient business. They’re using other people’s money to make a fortune.

The trouble is… sometimes unusual things happen… unusual things like a central bank selling off hundreds and hundreds of billions in short-term mortgages and Treasury debt into a market that knows that billions and billions more are coming.

In these unusual periods, short-term rates can rise to match, or even exceed, long-term rates. When that happens, the banks and mortgage companies can’t earn more (or anything) lending. They can quickly get into big financial trouble because they can’t finance their outstanding loan packages at a profitable rate.

Because of the Fed’s actions, there’s a high likelihood that 2018 will see one of these rare “inversions” between short- and long-term rates. This so-called “inverted yield curve” would be the final “get out of the pool” warning before the storm.

As you can see in the chart below, the spread between two- and 10-year interest rates has been narrowing since 2014. It’s now approaching a critical level – half a percentage point. As the spread gets closer and closer to zero, it will become progressively more difficult for banks and mortgage companies to access capital, which will reduce the market’s liquidity substantially.

Let’s make a safe prediction: 2018 will see some big financial fireworks…

Amid the backdrop of tightening financial conditions and the Fed’s decision to remove hundreds of billions in liquidity from the financial markets, you have one of the longest-running bull markets in history, a record-high level of bullish sentiment, and a fading crypto mania that was the single-greatest speculative event in our lifetimes.

My bet is that we see a number of additional record highs in the equity markets, as this amount of investor euphoria will not die easily. Watch for something: At some point, you’ll see a new “lower low.” That is, at some point over the next six months or so, you’ll see a real dip in the markets. You’ll see the indexes fall below previous lows.

You’ll see some kind of important financial weakness. It might be a rise in bad loans (like subprime autos). Or it might be in bank earnings, thanks to a much tighter or even inverted yield curve. Something in the character of the market, something fundamental will change. Most investors won’t notice. But you will.

And you’ll know what’s coming.

Great bear markets don’t start when people are worried and the markets are quiet. They began in periods of incredible excitement and financial euphoria. They begin with markets at all-time highs, when speculation is rampant.

In summary… let me paraphrase Warren Buffett…

Your success as an investor can be predicted in a few simple ways, but I don’t believe any indicator is more important than your ability to be cautious when others are greedy and to be greedy when others are afraid.

Most of you weren’t subscribers back in 2009 and 2012, when we were “pounding” the table for investors to buy stocks. Both Steve Sjuggerud and myself made the largest equity investments in our lives back in late 2008 and early 2009.

Today, I’m telling you the opposite. Yes, stocks may still run higher. But this market is running on fumes. We will see it all fall apart this year.

Now… I’ve done my best to show you the macro framework as I see it…

I hope you understand why it’s particularly important this year. But honestly, it really shouldn’t matter all that much to your investment strategy.

Why not?

Because you can’t know if I will be right and a bear market will develop soon. And even if I’m 100% right, you could still easily make your biggest gains of this cycle in the final few months of the bull market.

In other words, even if there is a bear market and even if the markets as a whole end up down for the year, you could still make a lot of money by simply following your trailing stop losses and hanging on as long as you can.

So while I think you should be aware of these macro risks… and while I believe they’re even more important this year than they have been in more than a decade… I think it’s far more important that you simply follow sound investing principles, rather than try to time the market.

Here are the three things you should do this year (and every year).

No. 1: Make sure you truly understand how much risk youre taking.

I’m frequently astounded (and terrified) when I talk to individual investors, and they describe their strategies. A portly gentleman wearing overalls told me proudly at a Casey Research meeting in Boca Raton, Florida about six years ago that he’d mortgaged his house to buy junior mining stocks. He wasn’t worried about the pullback (which became a grinding, four-year bear market and probably wiped him out) because he was diversified across more than 30 different tiny companies.

The best way, by far, to understand how much risk you’re taking in your equity portfolio is to use TradeStops. Yes, we’re investors in that business. If you subscribe to that software platform, I will probably make a small amount of money from the fees you pay. But I don’t know of any other software system anywhere that allows you to easily (and automatically) enter your brokerage information and quickly receive an accurate assessment of the volatility of your actual portfolio.

TradeStops can tell you exactly how much risk you’re taking, both with your portfolio as a whole and across all of your individual positions.

My bet? If you’re managing your own portfolio, you’re probably taking at least twice as much risk as the S&P 500 Index. That is, if there’s a bear market and stocks fall 20%, your portfolio will most likely fall more than 40%.

If you don’t know how much risk you’re taking, you’re much less likely to guard against those losses. But if you do know how much risk you’re taking and which positions are the riskiest of all, you can do a much, much better job of running your portfolio safely.

(By the way, if you use a broker or an asset manager, it’s even more important for you to have this tool and this information. Why? Because you’ll have a much better sense for whether or not he’s doing a good job… or just taking a lot of risk in a bull market. Telling him where he’s taking too much risk will also let him know you’re not a knob.)

By the way, if you don’t have TradeStops or you won’t buy it, you can “spitball” this risk assessment by simply measuring the weighted average of the “beta” of your individual positions. A beta of “1” means that a stock has the same volatility as the market as a whole. A beta of “0.5” means a stock is half as volatile as the market. And a beta of “2” means it’s twice as volatile as the market.

You can generally find the beta on any security by using widely available databases, like Yahoo Finance. (Careful, though… sometimes the data are glitchy. So if you see a number that doesn’t make sense, check it using another source. Or… even better… just use TradeStops.com)

Once you understand how much risk you’re taking, my suggestion is that you rebalance your portfolio so that you take less risk than the S&P 500. Remember… you want to be cautious when others are greedy.

You can lower your risk by selling down risky positions and building cash in your portfolio. You can also lower your risk by adding hedges that have a negative correlation to the stock market, like short selling positions.

No. 2: Out of all of the studies Ive read about portfolio risk management strategies, nothing is more powerful than risk-based position sizing.

In other words, whether you follow “hard stops,” trailing stops, or “smart” trailing stops (which are based on a stock’s individual volatility profile)… the biggest improvement to portfolio performance came from using a position-sizing strategy that equalized the capital at risk in each position.

This year, give yourself the best chance at success. Rebalance your portfolio so that you’re risking the same amount of capital in each position. Again, you can do this with the click of a button by using TradeStops. You just link the software to your brokerage account, import your portfolio, then use the risk rebalancer to learn exactly how many shares of each position you should own. That way you end up with the exact same amount of risk in each position.

This allows you to use wider stops on your riskier positions because they will be far smaller positions than your safer stocks. And it lets you speculate in high-growth equities without taking on too much risk.

Again, if you don’t have TradeStops or aren’t willing to use it, you can approximate this approach by using each stock’s beta to adjust your position size. If a stock has a beta that’s less than one, then increase your position size until multiplying its beta by that factor will equal one. And do the inverse for stocks with betas that are greater than one. Doing so will give you a risk profile that’s equal to the markets. If you want less risk, then standardize to a beta of 0.99 or less, depending on how much risk you want to take.

The important thing is to make sure that you’re taking the same amount of risk in each position. Nothing else you can do this year is more likely to increase your portfolio’s return.

And yet… I’m certain that more than 90% of my readers will completely ignore this advice. So before you go on, ask yourself: are you really trying to become a better investor? Why not at least do the easiest thing, the thing that’s most likely to help you, first?

No. 3: Build your portfolio around our highest conviction, most capital-efficient recommendations.

While these “safe and boring” recommendations may not excite you or make you a killing in the short term, they are the best way to build real wealth in the stock market. Over time, nothing beats this approach.

The very worst time to buy stocks in my lifetime was November 2007.

That was the month when stocks hit their last high before the crisis of 2008. That was just before the S&P 500 went on to decline by almost 50% over about 18 months. It was during that month – virtually the worst time in history to buy stocks – that I was researching a company that I knew would become the best recommendation I would ever make in my career.

And I said so at the time.

On December 7, 2007, I sent the following to the subscribers of my newsletter, under the headline Our Best ‘No Risk’ Opportunity Ever

I have come to believe evaluating capital efficiency gives us a permanent edge in the market, as almost everyone else ignores this crucial variable… Few people even understand the concept.

And as my British friend Tom Dyson would say, “I am quite pleased” to tell you that we have an opportunity right now to buy one of the greatest consumer franchises of all time at a no-risk price. As you will see, this business is the utter picture of capital efficiency. Or in terms [Warren] Buffett would recognize, this company has among the highest returns on net tangible assets in the world, uses very little leverage, and has a balance sheet where economic goodwill dwarfs all of its other assets.

Best of all, this company has a unique corporate structure and the backing of a major state’s government. In this situation, the management is literally required by a state’s attorney general to do what is in the best interest of shareholders – or go to jail.

The longer you hold this stock, the more rapidly your wealth will compound, and you’ll never have to sell – ever.

Longtime subscribers might remember that famous issue of my newsletter. I’ve referenced it many times over the years… But today is an important milestone.

It has now been a little more than 10 years since I made that recommendation – which was to invest in chocolate maker Hershey (HSY). The company is one of the best examples in the world of a dominant, capital-efficient, noncyclical, consumer-franchise business. It rarely trades at an attractive price, but at the time, Wall Street was convinced that Hershey wouldn’t be able to compete effectively in the global markets against Cadbury, and so all was lost. We took advantage of this temporary dip in sentiment to establish a world-class, long-term investment. I begged my subscriber to put a meaningful amount of wealth in the company.

Of course, it’s easy to promise that long-term capital appreciation is certain. It’s much harder to deliver.

In this case, I forecast the total return would be around 15% annually for 10 years. I was wrong. The total return (assuming you reinvested your dividends at the time they were issued) was “only” 13.2% per year, or about 250% over the 10-year period. My apologies…

If you took my advice, you can console yourself with this: Compared with Hershey, the S&P 500 has grown 8.5% a year over the same period – and been about twice as volatile as Hershey.

Assuming you put $100,000 into the shares when I first recommended them, you’d own 3,173 shares. The total value of your shares would now be just a few dollars under $350,000. And here’s the best part: Hershey would have paid you more than $77,000 in dividends during the last 10 years.

If you wanted to begin spending these dividends, you’d be earning 8.3% a year on your original capital, a rate of return that’s likely to increase each year going forward.

But if you have these shares, I’d recommend simply continuing to reinvest the dividends because the compounding returns are just getting started. I promised when you bought this stock back in 2007 that you had a good chance of earning 20 times your money over 20 years. That assumed a 15% total annual return, for 20 years.

Although we have been trailing that prediction, slightly, Hershey continues to grow its business and its dividend, and it has retained its economic goodwill and thus its capital efficiency. There’s no reason to change a thing. Just set it aside, and we’ll check on it in another 10 years.

As I told you back then, “This stock could easily become the best investment you make in your entire life.”

(Subscribers can read the entire issue, here.)

I want to make three points about our Hershey recommendation…

First, even though we recommended the stock at virtually the worst possible time in the history of the stock market, we’ve still done great. And we never stopped out of the stock. Why? Because we bought at the right price, and we bought a high-quality, simple business, that we could easily understand and evaluate.

Most investors, especially at this stage in the market cycle, only pay attention to stuff that’s promising to change the world. Those investments are always difficult. They’re extremely volatile. And very, very few of them will produce returns in excess of Hershey’s, over the long term. Thus, if youre simply willing to be patient, you dont have to be daring to get rich in stocks.

Second, it took the stock almost five years to really deliver any capital gains. As late as 2011, Hershey’s shares had hardly budged – up less than 20% from our original purchase.

My point is that when you buy a great, long-term investment, it shouldn’t matter much whether you buy stock today or next week or next month. And that’s good: Great long-term investments always offer you plenty of opportunity to buy more shares. Don’t doubt your analysis as long as the company continues to deliver on its model. Just buy more. And wait.

Third, it’s virtually impossible for other kinds of businesses to beat capital-efficient companies in the long term. If you don’t understand why, let this be the year you finally uncover this secret fully. It will change your life forever.

Hershey doesn’t have to spend much (hardly anything at all) to maintain its plants and grow. It’s been making the same basic product for more than 100 years – a chocolate bar. There’s no radical R&D required, and no new massive factory build every five years. Thus, as sales expand, more and more of the profits can be distributed to shareholders via dividends and share buybacks. Over time, this advantage compounds and becomes almost unbeatable.

In the letter where I recommended Hershey, I also criticized the corporate governance at Oracle (ORCL), which was (and still is) a popular technology company. Oracle makes some of the best corporate database software in the world. It has very good products that are high margin and “sexy.” But I had no doubt that Hershey investors would make far more money over time. And I was right. Oracle – the sexy tech darling – is up about 150% in the period, or 100 percentage points less than Hershey’s total return.

And one more thing…

The month before I recommended Hershey, I recommended another, very capital-efficient business that was woefully out of favor with investors – the homebuilder NVR (NVR). I explained why you should expect to see returns of around 25% a year for the next 10 years as the company would easily survive the housing crisis and continue to produce incredible results for investors.

I was right. NVR has produced total returns of more than 600% over the past 10 years, more than 20% annually. And I was exactly right about the price action, too. It was volatile and bottomed at less than $450 per share.

The only problem was, I lost my nerve and recommended selling NVR in May 2008… a few months before Fannie Mae (FNMA) and Freddie Mac (FMCC) imploded. I should have stuck with my original research, which was right on the money.

So remember: When you make long-term investments in high-quality businesses, don’t let the macro factors scare you out of your position. As long as the company continues to execute according to its model, stick with the position.

That’s the best, safest, and surest way to get rich in stocks.

Let 2018 be the year you begin to make only high-quality, capital-efficient, long-term investments.

In about 10 years, you’ll think it’s the best decision you’ve ever made.

Regards,

Porter Stansberry

Crux note: What Porter is predicting isn’t just another stock crash… it’s a total financial reset. And it could change America forever. Read more right here.

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