Porter Stansberry: How I'm preparing for the next bear market in stocks

From Porter Stansberry in The S&A Digest:

I’m afraid you’re not going to like today’s Friday Digest. It deals with the serious risks to equity prices in the U.S. and how you should handle your portfolio. I’d like to give you a simple barometer to watch – something that will serve as an “early warning” indicator for us. I’m nearly certain you’re not watching this indicator yet. You may have never even heard of it before. It’s something CNBC won’t tell you about. It’s something that will help us get out of stocks before the ongoing correction because of the bona fide bear market.

Here’s the ironic part… just telling you about this indicator is probably going to cost me a lot of money, perhaps even millions of dollars.

You see, we have a lot of subscribers that never want to read anything about risk or the likelihood that stocks will fall in price. And every time I write an essay like this… something that’s generally bearish… and perhaps a bit more sophisticated than what they’re used to seeing in a newspaper… they immediately cancel their subscriptions.

If that’s your knee-jerk reaction to today’s essay, I truly hope you’ll reconsider. The tools you’ll gain from today’s essay might someday save your retirement nest egg.

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On the other hand, longtime subscribers will surely wonder why I continue to write and publish essays that I know most of my subscribers won’t like or read and may even inspire them to cancel. Why on Earth would I write an essay that’s likely to cost me a lot of money?

There’s a simple answer: I believe these ideas are important, useful, and could potentially save you from catastrophic losses. Furthermore, this is precisely the information I would want, if our roles were reversed.

So far this year, in nearly every Friday Digest, I’ve been warning that most of the popular stocks in the U.S. were radically overvalued. I’ve been predicting a correction of up to 50% in price, based on earnings multiples. I’m sure you’ve noticed that many of the stocks I specifically warned about – Amazon (AMZN), Twitter (TWTR), Tesla (TSLA), etc. – have “tanked.” Yes, expensive stocks have begun to correct substantially. Amazon, for example, is down more than 25% this year. Tesla is down 25% from its peak. And Twitter has crashed by half since January 1.

The selloff of expensive stocks hasn’t hurt the broader market… yet. The S&P 500 is still up over all relevant time periods from five years to one month. No, most stocks haven’t fallen yet. And, they probably won’t until… the corporate bond market starts to fall.

That’s the barometer I’d like you to watch carefully…

The following chart is of one of the biggest exchange-traded funds that holds corporate bonds, the SPDR Barclays High Yield Bond (JNK). This shows you the last six months. As you can see, bonds (in black) have continued to trend higher. The fund holds nearly $10 billion in corporate bonds with an average yield of less than 6%. As long as yields on corporate paper are this low, it’s unlikely we’ll see a bear market develop.

Big institutional investors constantly evaluate whether to own more stocks or more bonds. Much of their decision-making is driven by what they can earn in bonds. When corporate bonds offer relatively high yields (8%-10%) annually, a lot of big institutional investors will opt to sell stocks and buy bonds. Doing so allows them to “lock in” gains and earn relatively high returns on their capital, with much less risk.

That’s why I don’t anticipate a significant bear market in stocks until corporate bonds begin to fall in price. Remember, bond prices move in the opposite direction from their yields. So a big fall in bond prices would send yields soaring. And that would drive investors to shift capital from stocks to bonds.

What will eventually drive a move down in stock prices will be higher interest rates. That hasn’t happened yet.

Part of the reason the corporate bond market has been so strong (and yields have stayed so low) is the Federal Reserve’s bond buying. The Fed has forced interest rates lower across the entire spectrum of the bond market. Buyers seeking yields of more than 4% have been forced into the corporate bond market and further out on the risk spectrum, too.

But that’s not the only thing pushing investors into bonds right now. Risks to economic growth have materialized over the past few months: Wal-Mart’s sales declined over the past five quarters, as did U.S. industrial output in April. As a result, more and more investors have decided to buy government bonds to avoid credit risk. This has forced the benchmark interest rate in the U.S. (the 10-year Treasury note) back to around 2.5%. Rates this low indicate that many bond investors fear the U.S. economy could dip back into a recession over the next year. In the short term, this big move down in interest rates has led to high prices for higher-yielding corporate bonds.

But here’s the rub… if the U.S. economy does weaken, then defaults on corporate bonds will begin to increase, substantially. The credit mix in the U.S. corporate bond market has never been weaker. The government’s actions to save the major banks back in 2008/2009 allowed many poor credits that should have gone bankrupt to make it through the last recession.

Martin Fridson, the leading corporate bond analyst in the world, expects to see more than $1 trillion in corporate bond defaults, beginning in 2016. Fridson says the annual default rate will approach 10% at the end of this cycle. With interest rates on corporate bonds at less than 6%, there’s simply no way that investors in the bonds are going to make money. They’re not being paid nearly enough to make up for the risk of default.

That’s why I believe the corporate bond market is “perfectly hedged”: It’s sure to fall, no matter what happens. If the U.S. economy rebounds strongly in 2015 and produces more growth than the market currently expects, then interest rates will rise – especially as the Fed stops supporting the market with the end of quantitative easing. In that scenario, corporate bonds will fall as interest rates rise. If this happens, it’s possible that earnings growth in big companies will increase enough to prevent a full-blown bear market in stocks. But a correction of 10% in the major indexes is still likely.

On the other hand, if fears about economic growth are valid, then default rates are going to soar. It’s likely that 30%-40% of all the issues currently outstanding will default during the next credit cycle. Fears of these future default rates would cause the corporate bond market to collapse. Interest rates on corporate loans would move to more than 10%. In this scenario, I’m certain you’ll see a full-blown bear market in stocks (a fall of 20% or more in the major indexes).

What should you do?… First and foremost, follow the corporate bond market. If you don’t own a lot of risky stocks or corporate bonds, you can simply watch and wait to see what happens. If you do own risky stuff, tighten your trailing stops.

And don’t be afraid to sell some positions and raise cash if necessary. You can watch the high-yield corporate funds as indicators. The big two are JNK and the iShares iBoxx High Yield Corporate Bond Fund (HYG). If you see these funds begin to fall sharply, with their yields moving to more than 10%… you’ll know a bear market in stocks is on the way. Raise more cash then.

For myself, with another 20 years or so to save for my retirement, I’m not particularly concerned about a bear market. I’d welcome it, in fact. What I’m concerned about is having enough cash on hand to take advantage of the lower stock prices that I believe are likely over the next year.

So right now, I’m holding only my best, most conservative, long-term investments. I’m not buying any speculative stocks. And I’m holding more and more cash. In the model portfolio of my Investment Advisory newsletter, we’ve focused on adding conservative ideas and building up our short portfolio to hedge against the risk of a bear market.

No one can know for certain what will happen with the economy… with the Fed’s bond buying… with the huge amount of debt that U.S. corporations are holding… or with stock prices.

Please don’t take my warnings as “gospel.” I don’t have a crystal ball. I do, however, have access to many concerning facts about interest rates on corporate debt and the corresponding impact higher bond rates will have on stock prices. Stocks are not cheap today. And bonds are ridiculously expensive. At some point in the coming months, I’m willing to bet that both stocks and bonds will be a lot cheaper and thus a lot more attractive for investors.


More from Porter Stansberry:

Porter Stansberry: I’m giving away the 12 greatest investment secrets I’ve ever discovered

Stansberry Radio Interview Series:  This is how Porter Stansberry really built his fortune

Porter Stansberry: A major correction is coming. Here’s what to do…

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