We have a bona fide Wall Street legend on the podcast today – Marty Fridson, referred to as the “Dean of High Yield” because of his unique knowledge of toxic loans to unworthy companies and their inevitable consequences as a Sword of Damocles on the broader markets.
Marty knows where the bodies are buried – and when the day of reckoning arrives, Porter trusts him to know which bonds will blow up and which ones will survive. That’s vital for anyone looking to prepare for the credit correction Porter’s forecasting will begin later this year, accelerate in 2019, and peak in late 2019 or early 2020.
But first – Porter, without the benefit of co-host Buck Sexton’s presence, dives into the latest controversies of the day, from reverse racism to #MeToo champion Asia Argento’s own sexual predatory sins.
Later the talk turns to Tesla – and why Porter, despite his total lack of faith in Tesla stock, admires Elon Musk as an entrepreneur even while shorting Tesla three times.
Just before welcoming Marty, Porter reveals one statistic in the market that’s warning that stocks are getting more expensive – just as defaults are creeping up outside America’s top 100 banks.
Chief Investment Officer, Lehmann, Livian, Fridson Advisors LLC.
Announcer: Broadcasting from Baltimore, Maryland and New York City, you're listening to the Stansberry Investor Hour. Tune in each Thursday on iTunes for the latest episode of the Stansberry Investor Hour. Sign up for the free show archive at investorhour.com. Here are the hosts of your show, Buck Sexton and Porter Stansberry.
Porter Stansberry: Hey everybody. Welcome back to another episode of the Stansberry investor Hour. I'm the founder of Stansberry Research, Porter Stansberry, and I'm alone in the driver's seat this week as my cohost Buck apparently has found something better to do. But never fear, we have a great show lined up for you. We'll get right into it, and keeping me company today as always is the infamous Country Club Guy. You might recall Country Club Guy is a former big league Wall Street trader.
Country Club Guy: Minor league.
Porter Stansberry: Who now basically plays a lot of squash and golf and keeps me company.
Country Club Guy: I get paid well to do it.
Porter Stansberry: Country Club, Guy, how are things?
Country Club Guy: Everything is great. I'm glad to be in I guess the cohost seat.
Porter Stansberry: Yeah, you got upgraded, but that comes with actual responsibilities, Country Club Guy.
Country Club Guy: Am I gonna have to talk today?
Porter Stansberry: You might have to order me some more web belts and some new shirts.
Country Club Guy: How about if I try to read an email today if I can get that out of my mouth? Buck is in L.A.
Porter Stansberry: Country Club Guy doesn't do well with reading out loud. He's struggled since third grade.
Country Club Guy: Yeah. Brings me back to Lutherville Elementary in 1984.
Porter Stansberry: All right, listen, we wanna get to some things that are gonna be useful for you, and I wanna tell you on the podcast today we have a bona fide Wall Street Legend. Marty Fridson is his name. He's referred to the street as the dean of high yield. What that means is he knows more about how loans to unworthy companies are made and traded and packaged and syndicated I believe the word is, Jammer, they use, syndicated.
Country Club Guy: Syndication. Yeah.
Porter Stansberry: Syndicated. He basically, Marty knows where all the bodies are buried, and when the next default cycle comes he knows which bonds are gonna blow up and which ones won't. So spending a little time with Marty is good preparation for a big credit correction that we believe is still gonna occur beginning later this year, accelerating in 2019, and probably peaking at the end of 2019 or the beginning of 2020. So there is a real financial reason to listen to us be a bunch of numbskulls today on the podcast.
But first before we get to the stuff that you can actually use, you're gonna be subjected to a bunch of mindless opinions and bad inside jokes. Let's start with a topic that's near and dear to my heart. I like the whole reverse racism angle that goes on in our country these days, because I've never, ever passed a judgment against somebody because of the color of their skin or because they were a male or a female, but I see more and more of that going on every single day. I don't see how you can cure racism with more racism.
Maybe that's just me. I also don't understand how you cure a credit crisis with more credit, but there are a lot of things I don't understand. But I did wanna point out two things to you, Jammer. First of all this poor, what was her name? Asia Argentino? This poor woman who was sleeping with this teenage boy, and I wonder if that had anything to do with the suicide of the chef guy, Bourdain.
Country Club Guy: Well, it hadn't come up until now, but I'm sure it'll come out. Probably had something to do with it.
Porter Stansberry: I wonder if he knew about it? I wonder if that's what upset him so badly that he would kill himself?
Country Club Guy: Apparently she was receiving pictures or unwanted pictures from the boy when he was below 16 years old.
Porter Stansberry: Yeah, I don't know. Seems like you'd tell his mother if you were doing the right thing.
Country Club Guy: Or brag to your friends, one or the other.
Porter Stansberry: No.
Country Club Guy: I'm just kidding.
Porter Stansberry: Definitely do not want unsolicited pictures from teenagers ever. Anyways, I just think that it's interesting. the media has already condemned Harvey Weinstein, and I know my producers have already told me I'm not allowed to talk about Harvey Weinstein 'cause my opinions are so contrarian about this matter, but I really do think there's a global double standard and I wanna point out a place where it is really leading to some severe violence and a lot of wrongdoing and that's South Africa. I know most investors in America could care less about South Africa.
I bring it up for a couple of reasons, but the main economic reason is this one. We all believe that we're in a modern world where property rights are sacrosanct. We all believe that we've overcome the scourge of communism. Even in China people have the right to private property. Even in Russia people have the right to private property. The idea that a government can just decide to confiscate your property without compensation, everyone believes that that's long in the past, and that has enabled things financially that are truly remarkable.
Like for example, you guys might not know this, but Venezuela of all people at one time sold a 50-year government bond. Imagine what that bond is now worth considering that they have devalued their currency by a million percent or several million percent. So investors who trust people in these countries and in foreign cultures where there may not actually be much of a history of the rule of law are probably taking chances that they don't really understand. In South Africa what's going on is Black people of course have been disenfranchised in South Africa for many, many, many decades, probably more than 100 years apartheid. No one is justifying that.
No one is saying that that was the right thing. No one is saying any of that stuff. But when the white people who had power decided to share power with the Black majority, they took a number of steps in the Constitution to make sure that there wouldn't be this kind of financial or economic retribution. So what's going on now maybe ten years after the death of Nelson Mandela? Well, the South Africans are confiscating white farmers and there is unfortunately a rise in these Black paramilitary groups. There's some guy, I don't know him, but his name is Simon Black apparently and that's the newsletter guy Simon Black.
Country Club Guy: That's who I thought it was.
Porter Stansberry: They call this guy – I'm sorry, Simon Black is the newsletter guy. This guy's name is Malema, and Simon Black has been warning people that he's like a Hitler kind of figure, and he's saying that he's not gonna urge genocide against white people in South Africa yet.
So anyway, I just wanna point out to people, I mean I have good friends and partners who've bought a lot of land in Nicaragua. I have good friends and partners who've bought a lot of land in Argentina. I know lots of people who have bought land in Ecuador. I don't know anyone who's bought a lot of land in South Africa.
I have a good friend who lives in what used to be Rhodesia, now they call it Zimbabwe. He's actually an orange farmer and he's a white guy and is threatened by all this. But I think it's just an important concept for you to have in your mind that governments that sound all nice and friendly and propose good terms for investors, they may not keep their word, and I would suggest that that includes the government that we have here.
Country Club Guy: I was just gonna ask you, we talk about reparations for many years, certain groups call for that, "Hey, give me what's mine. We were forced into slavery back in the day." Is this gonna happen in the U.S. at some point?
Porter Stansberry: Well, I would go a little step further. I'd say that the reparations have long since been here. I mean what do you call the incredibly steep rates of progressive taxation? I mean there's this thing called the 14th Amendment that says the federal government is required to treat all citizens equally under the law, but if I pay a marginal tax rate of 54 percent and 99 percent of the people who live in the city of Baltimore pay a marginal tax rate that's negative, in other words they're net recipients of largess from the federal government, what's really happening?
Country Club Guy: I would say technically that's what you would call reparations, but I'm talking about seizing your land. I know they won't come to your house 'cause I know how many guns you have.
Porter Stansberry: No, they might. They got way more guns than I do, and believe me, fighting back is not gonna work.
Country Club Guy: I'll be there with you and we'll have fun.
Porter Stansberry: No, we're not going out in a blaze of glory. We're going out on a private plane to Switzerland. That's what we're doing and we're taking our money with us.
Country Club Guy: I know, but this is a dire example of seizing land and I'm assuming people are being killed over this. I don't know. I haven't read any stories, but when you go and seize somebody's land, aren't they gonna defend themselves?
Porter Stansberry: Of course they are. I'm sure there will be violence. But the thing about all this stuff that I find so funny, and I understand that most people don't understand why this is a laughing matter, it certainly wouldn’t be a laughing matter if they were coming after my family farm or me, so this is a matter of perspective, but what I find ironic, not funny, ironic about it, is that who these policies really end up hurting of course is poor people, not rich people.
Because like I just said, what rich people in South Africa are gonna do is they're gonna buy a second passport in Switzerland, they're gonna convert their savings into Bitcoin or into gold or just wire the money and buy a foreign currency. Very few people I think are stubborn enough or foolish enough to sit around and fight for their nation when their nation is a majority of Black people who are okay with confiscation. That doesn't seem like good neighbors. I think I'd wanna move. Maybe some people will fight. I'm certainly not a fighter.
Country Club Guy: And is this an interjectable thing to do for the U.S. to get involved?
Porter Stansberry: But I wanted to point out a larger issue which is that this idea, whether it's something that most people consider a very minor infringement upon their rights like progressive taxation, or whether it's something major like confiscation of farms, all of these things have negative economic consequences, and the negative economic consequences are not for the people who you'd think. Marginal taxes mostly hurt folks who do the right things in America, the folks who worked hard to go to college, who worked hard to build a career, who end up being employees. Very wealthy people like me don't pay much income tax.
Country Club Guy: Who has two thumbs and is wealthy? This guy.
Porter Stansberry: Who has two thumbs and doesn't have much income but has a lot of wealth? Buffett points this out. I think Buffett's salary is $100,000.00 a year. That's what he's paying income tax on. But look at the amount of wealth increases every year in the billions for Buffett, but it's in the form of capital gains that are not taxed because he's not selling, he's holding, and that's my point.
When you try to go after taxing, the idea that the democratic mostly party sells voters is, "Vote for me. I can deliver you your neighbor's wallet. I can give you public education, I can give you public transportation, I can give you public healthcare" when reality what they're giving you is poverty because they're making it difficult or impossible for wealthy people to invest, to build the resources that would actually provide those goods.
And if you've ever been on the receiving end of government largesse, if you've ever had to deal with government largesse, you'll understand how awful it always is. Trust me on this. Remember Obama's promise, if you like your doctor you can keep your doctor? Bullshit. Why? Because your doctor is never gonna work for the government because that's a shit job that no one wants.
Country Club Guy: That lasted about ten seconds.
Porter Stansberry: So I guess I'm preaching to the choir by telling you guys this, but when I see stuff going on like I see in South Africa, when I see stuff going on like I'm afraid is happening in Nicaragua, when I see stuff going on like continually goes on in America, although Trump has reversed a lot of it, I don't worry about me. You can tax me whatever you want. I'm still gonna work harder and better than the next guy.
I'm gonna be fine. I worry about the poor people living in the inner city of Baltimore 'cause they're the people who are gonna really suffer. All right, so that's my rant about government and confiscation and taxes and poverty. You've probably heard it before. What else is going on?
Country Club Guy: Should we talk about our weekly update on Tesla?
Porter Stansberry: Well, Tesla is just a complete carnival these days. I mean what boggles my mind is that the guy can come out and blatantly violate securities laws. I don't care whether you like Tesla cars. I don't care whether you like Elon Musk, and I agree he's a great entrepreneur. The guy comes out and just blatantly violates securities laws and the stock doesn't even budge. I mean talk about a cult. It's very impressive.
Country Club Guy: It is impressive. I've read the book, the Elon Musk book by Ashley Vance. I think it's Tesla, Space X, and The Continual – I can't remember the rest of it, but after I read it I said I would never bet against the guy and the guy being the guy leading the company, but I know there's a lot of things going on with Tesla behind the scenes.
My point is that I was a big believer, I would never short the stock, and now I think the curtain is unveiling behind the scenes. He's staying at the plant until 4:00 AM. He's putting cars together himself. How long can he keep this up?
Porter Stansberry: I don't know. I truly am impressed with him as an entrepreneur. What he's done is incredible. I just, I fear for investors who believe that accomplishment is gonna translate into a stock value that's larger than Ford. It just doesn't make any sense to me. I've been wrong before. I think I shorted the stock three times in my newsletter.
I've lost money all three times. I'm done. I do not have a professional opinion on the stock anymore, and I admire Elon Musk's ability as an entrepreneur, but again I just don't understand why is it that some entrepreneurs like Elon get huge grants from government, huge tax breaks, right?
Rich people buying those cars get I think $7,500.00 in tax credits. Why are we subsidizing rich people buying sports cars? It makes no sense to me. And then again he can just trounce all over the securities laws and nothing ever happens. What I'm saying is there shouldn't be two sets of rules for companies or for people. We should all play to the same set of rules.
Country Club Guy: Good segue there.
Porter Stansberry: Let the market decide. By the way, he wasn't the only famous California entrepreneur who trounced the securities laws. People forget this, but Apple, Steve Jobs. Steve Jobs -
Country Club Guy: Refresh my memory 'cause I don't remember.
Porter Stansberry: Steve Jobs circa '07-'08 re-priced all of Apple's options including his own and then backdated them to the lowest price of the year.
Country Club Guy: You're not allowed to do that anymore.
Porter Stansberry: You weren't allowed to do it then. The CFO for Apple ended up taking all the heat, almost going to prison, and people paid a lot of attention to it, but they said, "Oh, it wasn't Steve Jobs's fault." It was this CFO guy, I forget his name. Well, CFO came out publicly and said, "Steve Jobs told me to do it" and that was after all the litigation was over. He wasn't squealing to dodge the blame. He took the blame and then said, "Steve Jobs told me to do this."
Here's what nobody ever investigated. What about Steve Jobs's other company where there wasn't a CFO to take the blame? Talking about Pixar Animation. Everybody forgets that Pixar was a public company before Disney bought it, and who was the chairman and the CEO? Steve Jobs. How much backdating went on at Pixar? The same amount that went on at Apple. And who directed it? Steve Jobs. And what happened? Nothing. Anybody wanna know why? Guess who ended up on the board of Apple circa 2007? Al Gore.
Country Club Guy: AL Gore, a man for the people.
Porter Stansberry: Well, he invented the internet.
Country Club Guy: Yeah, of course.
Porter Stansberry: I'm sure we couldn't question his judgment.
Country Club Guy: He would question why people were driving SUVs, meanwhile he lived in a 14,000 square foot house.
Porter Stansberry: An inconvenient truth that Al Gore is a complete crook and so it was Steve Jobs. Listen, that Steve Jobs broke securities laws and robbed his shareholders, does that make him a bad person? I mean not – he did a bad thing.
Country Club Guy: Who's the victim in that case?
Porter Stansberry: He also did tons of good things. He created Pixar. He created Apple. He created tons of products that we all love and using including me, but what I'm saying is he shouldn't be above the law. By the way, any time I criticize Steve Jobs, look out, here comes the hate mail.
Country Club Guy: Oh, I'll send you some, not personally, I'll just forward on the people that -
Porter Stansberry: I gotcha.
Country Club Guy: Yeah.
Porter Stansberry: Anyway, I think it's funny that people wanna overlook. It doesn't make sense to me. I don't know why there's two sets of rules, but there are. Okay, moving on. Let's see, when's Marty calling in? About five minutes. How about this, Jammer? The S&P 500 median value price to free cash flow ratio is now 34.5.
Country Club Guy: I saw that, and you're gonna have to explain that to me and the listeners because my tiny brain that means there's 35 years worth of cash on the books to have the company solvent?
Porter Stansberry: No. That means that in terms of the market cap, so if we're talking about how many years of cash flow it would take for the median company to buy back all of its stock it would be 35 years.
Country Club Guy: Oh, I gotcha.
Porter Stansberry: So it's another form of a PE ratio. It's basically saying that not including all of the non-cash charges like depreciation and things like that, the S&P 500 has a PE ratio of 35. Now the real PE ratio is probably something around 20, 21, 22, but this is interesting because more and more of the earnings of the S&P 500 are tech companies and they have very little depreciation. So the cash flow measure becomes more and more important as the nature of that index changes. But it's just another way of saying, boy, stocks are getting really expensive.
I think probably the peak of that measure was back in 2000 when it was something around 50, so we're not to the point of the 2000 bubble in this measure, but we're definitely more expensive, besides 2000, stocks are more expensive than they've ever been every in history, more expensive than they were in 2008, more expensive than they were at the top of the market in 2009, and that doesn't mean that the market is gonna crash right now. It just means that if there is a significant economic event, if there is a hiccup, if there is a so-called black swan, stocks could fall a long, long way.
So I think that's – of course that's true at the top of any bull market, and this has been a very, very long bull market no matter how you measure it, which we talked about in the last show. One thing that I find interesting though is that so much of this bull market is being propelled by credit, and I know we're gonna talk with Marty about that. Let's talk about just one form of credit, which is credit cards. So we have personal debt now at an all-time high.
Let's see, I got the facts here somewhere. Where did they go? Here it is. Subprime credit card balances and total consumer debt. So total consumer debt now is $4 trillion. Technically it's $3.9, but who's arguing? I mean $4 trillion. Can you imagine that, consumer debt at $4 trillion?
Country Club Guy: That's a lot of irresponsible consumers.
Porter Stansberry: Be clear what this is. That's auto loans, that's credit cards, and that's student loans.
Country Club Guy: That doesn't include mortgages.
Porter Stansberry: Doesn’t include mortgages. This is consumer debt. I mean this stuff has pretty high interest rates. That's gotta be a huge drag on the economy, and it also means that a lot of people aren't gonna be able to pay it. So the delinquency rate on credit card loan balances at commercial banks is rising, and it's particularly rising outside of the top 100 largest banks. Now why would that be? Well, the largest 100 banks can make money in a lot of different ways. They can make money mostly by lending to corporations. The smaller banks make a lot of money by lending to mom and pops, lending on cars, lending on credit cards, that kind of thing.
So at all the banks except for the largest 100, and that's essentially the whole banking system, I mean that's 5,000 banks as opposed to the top 100, the default rate rose to 6.2 percent in the second quarter, and that is higher than the default rate at the peak of the financial crisis by a full percentage point, and it's up from just 4 percent a year ago.
So what I think is going on, I think it's very important for people to understand this, is there's already a hidden default cycle that's starting, and because we don't see it in the 100 largest banks it's not showing up in the overall statistics, but it is certainly showing up in the real lives of people on Main Street. I don't know how much longer Wall Street can keep the game going. It's like hide the peanut game, the shell game.
Country Club Guy: Yeah.
Porter Stansberry: When Main Street is suffering. As a great example of this, look at the share price of GM and Ford. That's Main Street. Ford is at $10.00 a share. Stock hasn't gone anywhere -
Country Club Guy: In years.
Porter Stansberry: - in a decade. Look at GM. GM went public. The new GM went public at $35.00 a share. Where is it today a decade later? $35.00.
Country Club Guy: $37.00. Yeah.
Porter Stansberry: Hasn't gone anywhere. I think that's really interesting – Marty is on the phone – I think it's really interesting that the economy has taken off, tech stocks have taken off, consumer spending is way up, consumer borrowing is way up, but hang on, we got these rising huge default rates on credit cards. We got huge default rates on student loans, and we got core Main Street American companies that can't make any money. It's a fascinating economy.
Country Club Guy: Our guest this week is Marty Fridson. He's the chief investment officer at Lehman, Libby, and Fridson Advisors, and widely respected in the fixed income space. He's the author of six books on investing and economics. Marty was dubbed dean of the high yield bond market by Investment Dealers Digest. Please welcome Marty.
Porter Stansberry: Marty, thank you very much for joining us today. It's always a tremendous honor and a privilege to talk with you.
Marty Fridson: Good to be here.
Porter Stansberry: I wanna jump right into it. I've already introduced you to the audience. They know that you are the dean of high yield on Wall Street, and one of the big topics for folks who focus on credit issues is the growth in the BBB tranch of investment grade debt.
A lot has been made about the risk to this, and for folks who are new to the credit markets, BBB is the lowest quality that's still considered an investment grade. Why that matters is historically investment grade credits have very, very low default rates even in times of tremendous economic stress. So Marty, you know the facts better than I do. What's the peak annual default rate in the investment grade world?
Marty Fridson: Oh, it doesn't really get above 1 percent even in the BBB category. That would be a high level.
Porter Stansberry: And that's why, folks, because these kinds of bonds are so safe, and I can't say that they never default 'cause like Marty just said at peak periods of stress you'll have 1 percent of them default, but I mean essentially if you can just use a general term these things are rock solid. So because of that they're able to borrow enormous amounts of capital, and Marty, you know the totals, but what's the size of the investment grade outstanding debts compared to the high yield side of the market?
Marty Fridson: Well, I can give you some pretty precise figures right here.
Porter Stansberry: I figured you'd be able to.
Marty Fridson: Currently the investment grade index, _____ _____ Maryland _____ Corporate Index, which is the investment grade index, has a face value of $6.3 trillion, and that compares with the high yield index, again these are both U.S. figures, of $1.3 trillion, so four to five times greater.
Porter Stansberry: Right. So much more money has been borrowed by corporations that have investment grade credit than high yield subprime so to speak credit. And Marty, the problem with BBB is that in this cycle there has been so much investment grade credit that's been downgraded into BBB, and they have borrowed so much money that now BBB as I understand it makes up more than 40 percent of all of the outstanding investment grade credit. Is that correct?
Marty Fridson: It's actually almost 50 percent now on a market value basis. Now I should emphasize that some of that represents downgrading from higher credit ratings, AAA, AA, or A. Some of it is just large issuance at the BBB level. There are a number of different moving parts to those ratios.
Porter Stansberry: That's right, and I'm one of the people who have looked at these numbers and worried about them because my concern is that you could conceivably have a situation, I'm not saying it'll occur tomorrow, but I'm saying you could conceivably have a situation where you'd have a really large amount of issuance become what's known as fallen angels, and that's when companies that used to be investment grade credits get downgraded to the point where they're no longer investment grade credits and they become junk bonds.
Those issues can be very hard to deal with because there are a lot of firms that are not allowed to own a bond if it's not investment grade. So there's a much lower volume of trading and less investor interest in stuff that isn't investment grade. Now Marty, you have a different opinion and I'd like to get to the bottom of that. Why are you more sanguine about the future of these BBB credits in the next credit cycle?
Marty Fridson: Well, let me put it in perspective a little bit. I don’t dismiss the concerns by any means. This does represent a big change in terms of how things have looked in the past. Now by the same token a fund that had a standard of let's say only owning paper rated single layer better still has that same standard and they're able to buy enough debt to fill that, so that isn't a change. Just to put it in perspective, ten years ago the BBB's represented a third of the market value of the investment grade index, again very close to 50 percent now.
A couple things to keep in mind here. As far as the impact on the high yield market, we have had some previous instances. You mentioned a few moments ago General Motors. Well, the new General Motors came about because of the default, the bankruptcy of the old General Motors, but before they went bankrupt this was a company that at one time had a AAA credit rating, deteriorated over a long period of time, and then in 2005 dropped into the below investment grade category and BB the top rating in the high yield category or speculative category.
Looking at that and another instance of a large addition, a large amount of fallen angels, those investment grade bonds being downgraded to below investment grade, and on the face of it saying well gee, that's gonna create a lot of supply pressure, prices will get depressed, and it did have some impact with some analysis that worked on eliminating other effects that might've been going on at the same time and projecting what might happen in this current environment when you see a large volume of downgrading to BB from the bottom tier of the investment grade category.
You're talking probably of an increase in yields, all else being equal, of about a half a percentage point, a price drop of probably a couple of points as a result of that. So it's not an end of the world scenario by any means. One thing to keep in mind there is that while there are a lot of investors that are restricted in terms of owning only investment grade bonds, the response is not to immediately dump all of that paper in response to downgrade. I actually once called the five largest pension plan sponsors and asked them the specific question, "What is your policy?" If you have a manager whom you've given a mandate to manage investment grade bonds and a bond falls to BB, what's your policy?
And they say, well, we wouldn't want them to sell it immediately. That would be the worst time to do it. They'd be engaged in a fire sale. So we say to them, yes, your mandate is to invest in investment grade bonds, so we'd like you to divest that issue that has fallen below investment grade, but don't do it at a time that's gonna be counterproductive. So the shock effect of that downgrading can be overstated. Not something to ignore or dismiss, but important to keep in proper perspective.
Porter Stansberry: Okay. I got that. Marty, it's funny that you talk with those folks and I'm sure they were telling you the truth as they saw it at the time, but you and I both know like Mike Tyson said when you get punched in the face everyone's plans go out the window. Something goes on that's very countercyclical in the bond market because these prices do fall out of bed. You've seen it happen, I've seen it happen.
Marty Fridson: Oh yeah. When you get into a real bear market, and bear in mind that this is gonna happen most likely at a time when the economy as a whole is turning down. That's what causes risk premiums to rise generally.
Porter Stansberry: That's right. Marty, you know better than I do that there's a definitive correlation between the size of the credit run-ups and then the resulting default rates and the losses, and you've studied them more than anybody. So I'd love to know where you are on that today. We've had huge increases to corporate credit balances and outstanding debts and bonds. What's your gut tell you about the ultimate conclusion of this credit cycle?
Marty Fridson: Again, the defaults are going to occur 95 percent of the issues based on studies I've done in the past, occur in defaults already at the bottom of speculative grade spectrum, namely CCC or below. In the year in which they default they begin the year already at that level, so the defaults are not occurring in bonds as high as BB.
Some of those as happened with General Motors may get downgraded over a period of time to where they get to the range where they are at very high risk of near term default. I think the key point in this, and of course the downgrades are gonna increase the BB, the highest rated portion kind of paradoxically, the quality mix of the speculative grade category in the short-term will improve as a result of those downgrades.
It's always ugly on the way down, and when you get into a recession or you're approaching a recession and the market is reflecting the prospect of those higher default rates, the real problem is that the market makers step away from the market. It's not like the old time New York Stock Exchange where you had a franchise to trade a stock and you monopolied profits by doing that, but you did have the obligation of coming in and stabilizing the market in that stock if there was bad news on it. That's not the way the corporate bond market works.
There's no obligation by dealers to continue to make markets when it's headed down. The sure sign that you're In that environment is you'll start to hear the phrase, "Don't try to catch a falling knife." This comes back in every cycle, and what it means is that it's a suicide for the dealers who are acting on a principle basis. They're committing their own capital to buy the bonds in hopes that they can resell them at a profit, and if the market is headed down they know that they're gonna be selling them at a loss rather than at a profit.
So at that point they sort of stop the pretense that, oh, we always have a market. You may not like the market, but we're always there. They're not there. They've stopped picking up the telephone and then you really see a plummet. That's normal. That's happened in past cycles. It will happen in this cycle again.
Porter Stansberry: Do you have any idea of the scale of a mismatch and durations between the largest holders of corporate bonds now being probably the ETFs that have, what, weekly liquidity obligations and the reality of these markets where sometimes bonds won't trade for months if there's uncertainty about the future of the venture?
Marty Fridson: Yeah. Some of those bonds are 30 years in maturity and they do have immediate obligations to redeem shares. Now they have some stop gaps there they can redeem in kind, so there's some safety valves. ETFs still represent a pretty small portion of the data out there. They can make a difference at the margin and so it's not a concern again to dismiss entirely. It is important though also to keep in mind, the other concern people have about ETFs is that they're owned by renters rather than owners of the bond.
These are short-term players. They're looking to get in, get out, rather than being the more stable types of not quite buy and hold but at least longer term investors. That is a valid issue, but again it has to be put in the context of that's not entirely new for this cycle. While ETFs have grown tremendously, the high yield ETFs JNK and HYG were only introduced in 2007 so they really weren't there except at the real tail end of the last cycle, but there were other vehicles for those short-term players.
We're talking in a lot of cases about hedge funds who were looking to jump in and out of the market and those were open-end mutual funds that allowed those players. Some just said we don't want those investors in our fund, but those that did provided a vehicle for jumping in and out and were also a vector for that resulting volatility into the underlying cash market.
Porter Stansberry: Well Marty, do you have any idea of the timing of when the next default cycle will really begin? I don't know where we are right now in the default rates, but I know they're generally very low and benign, and I think everyone has been waiting to see some kind of an uptick in that indicator and so far there's just been nothing.
Marty Fridson: Yeah. That's absolutely correct and that's related to the fact that this is a very long economic recovery. Leaving aside all the controversy about whether or not we're at a record lying bull market in stocks, it is an unusually long economic recovery, and I recall people looking for an uptick in the default rate as far back as 2013. Now the people who were pushing that idea most vigorously were distressed debt investors, in other words people who specialize in the debt of bankrupt companies where you can often buy them below their intrinsic value and wait out the bankruptcy and so on.
So of course they were eager to raise money and were promoting the idea that we're on the verge of an uptick and that hasn't happened. The long-run average default rate in the speculative universe is right around 4.5 percent. We're about a percentage point lower than that on a trailing 12-month basis, and the projected default rate for the next 12 months is actually lower rather than higher.
So probably we're talking about at the earliest late 2019 or 2020 before we'll see a really significant pickup in the default rate. That's barring you could have a very sharp drop in oil prices again and at least that sector, which is a very large one within the high yield market could see an uptick, and you did see that a couple years ago when you had a fairly stable default rate on the rest of the universe but a sharp spike that was enough because it is the largest sector within high yield to pull the overall default rate up to around the 6 percent level, but it has subsided since then. So default rates usually are connected.
Aside from that sort of partial spike and another similar one that occurred way back in 1986, ordinarily those surges in cyclical rises in the default rate getting up to peak of 10 percent or even more are associated with recessions, so you tell me when the next recession will be and I'll tell you when we're likely to see. But I would say on that score that Ben Bernanke recently joined the ranks of those who are expecting a recession. He used the more extreme, the economy really falling out of bed circa 2020.
Porter Stansberry: Well, it seems like every time I talk with you or other folks who are watching the credit market closely, it always ends up being about two years from now. It just keeps getting pushed back 'cause we don't see any signs of it yet and you know that it takes a while to heat up to get going, but Marty, we don't expect you to tell us the future, just to tell us what's happening now. So thank you very much for being with us today. I really appreciate it.
Marty Fridson: Really been a pleasure.
Porter Stansberry: I have to admit, Country Club Guy, I only understood about a tenth of what Marty was saying. A lot of that went over my head.
Country Club Guy: Well, I'm a tenth of your tenth, so I'm less.
Porter Stansberry: I think the bottom line is we don't see any real distress yet in the credit markets, and that Marty seems to think that the big growth in BBB is not as big of a problem as other folks, although I suspect that that tone will change in the event of a recession.
Country Club Guy: How often do you think he gets asked the question you asked about -
Porter Stansberry: He gets asked every day.
Country Club Guy: He chuckled.
Porter Stansberry: When? When? When?
Country Club Guy: His timeline is at least 12 months out if not longer.
Porter Stansberry: Always. I've been asking him since 2015; it's always two years from now.
Country Club Guy: Is it one of those things where he's gonna keep it a secret and then let you know when it's already happened?
Porter Stansberry: Exactly. It was 2017 when it was 2015, and then in 2016 it was 2018.
Country Club Guy: We had him in Vegas and I think everybody was asking that question.
Porter Stansberry: In fairness to Marty, and by the way, he's never said now and he's always said, "There's no signs of it yet." Last time we had him in Vegas I thought he was particularly almost bullish saying that there's just no reason to worry yet.
Country Club Guy: Hey Porter, it's time for the mailbag. Remember, everyone, your feedback is important to the success of our show. You can simply email us with a question or comment to [email protected] We read them all. We try to respond to every single one of them, even the hurtful ones.
Email number one, "Mr. Stansberry, you have spoken often of the risk of the massive financial downturn posed by the ballooning corporate debt and the increasing number of over-levered companies that are just a hair away from being downgraded to junk status. However, I have seen competing analyses that state that companies are also keeping a record of amount of cash on their balance sheets. If this is true, would it not limit the effects of the default cycle to only the most desperately indebted companies? I love the shows, but oftentimes you leave me with more questions than answers. Samuel K."
Porter Stansberry: Well, Samuel, I regret that you have more questions than answers. I can only tell you that it seemed apparent to me to think that the companies that have excess amount of cash on their balance sheets are not the same companies that are overly indebted, and that, however ironic, both things could be true. I think the corporate cash levels are mostly related to the enormous amounts of cash that you find on certain tech companies' balance sheets like Apple for example who's always had huge amounts of cash, Microsoft, Google.
If you look at the bottom 15 percent of the S&P 500 however you'll find a large number of companies, almost 200 companies, who cannot generate enough income to even pay the interest on their debts. So I think you could have a bifurcation in the market where you have a whole lot of bankruptcies whereas a lot of companies continue to do very well. Would that trigger an overall bear market, an overall decline of 20 percent in the S&P 500? I really don't know. We'll have to find out.
Country Club Guy: All right, on to email number two. "Porter and Buck, love the show as always and keep up the good work. I have a question for Porter." 90 percent of them are for you.
Porter Stansberry: Sorry.
Country Club Guy: "Talking about property and casualty companies, you keep mentioning that these companies get paid to hold their capital. When you say capital, are you referring to the float of these insurance companies? If so, does that mean that while that float is waiting to be used to pay out claims, they can in the meantime legally use that float to invest in stocks, bonds, precious metals, etc. to further increase the float, in essence getting paid to hold their capital. Would appreciate your response. Cheers, Jose T."
Porter Stansberry: Yes, Jose, that's precisely what I mean. That's the whole advantage to investing in property and casualty stocks. It might occur to you that for a life insurance company, what's that chart that shows you when people are gonna die, Jammer?
Country Club Guy: Actuary?
Porter Stansberry: The actuarial counts are gonna be the same and therefore the differences in underwriting are gonna be very, very small. Everybody dies. While it's true some people sell their life insurance policy or some people let it lapse, overall there's no way to gain a significant economic advantage in the life insurance business because everybody dies, whereas in property and casualty there are enormous economic differences in the underwriting qualities of the different companies.
So companies that specialize in good underwriting can end up not only with having a lot afloat, but they can end up avoiding paying a lot of claims, and that's how that float doesn't just get to be capital they get to hold for a small amount of time, it gets to be capital they keep forever. And property and casualty insurance companies have underwriting profits, that is they have profits related to premiums that never have any payout in claims. Those are the companies that we look for.
Sure, float is a very important part of the insurance company business model as well. Insurance companies are the only folks who get paid to hold capital. If you go give your capital to a bank, they're gonna have to pay you interest on it, but when you give your capital to an insurance company in the form of a premium you're paying them. That is a very significant difference in the financial business, and that's one of the main reasons why we like P&C stocks.
Country Club Guy: "Hello dear leader, Porter, and once in a generation radio host, Buck."
Porter Stansberry: You know, if Buck is really one in a million, what that really means is there's a million other people just like him in China.
Country Club Guy: Mm-hmm. Good call.
Porter Stansberry: Think about that.
Country Club Guy: He writes, "Recently a friend and I were talking about investing in tangible assets like fine wine, liquor, luxury watches, and fine jewelry", right up your alley, this is your question, "and of course precious metals. We both agree that gold and silver are obviously viable investments and are a great hedge, however neither of us could decide if high-end watches and jewelry and alcohol would be similarly reasonable investments or at least wealth storage. We would love your take on the subject. Tyler P."
Porter Stansberry: Country Club Guy, you're actually reading out loud.
Country Club Guy: Two in a row, baby.
Porter Stansberry: You're ready for third grade.
Country Club Guy: I can hit a golf ball 300 yards, but I can't read.
Porter Stansberry: You can't hit a golf ball 300 yards.
Country Club Guy: Downhill in the fall when the ground is really hard. Okay, answer the question, will you?
Porter Stansberry: You know, I have two minds about this, which I do often have answers that go out of both sides of my mouth and people don't understand the nuance and the difference. I would agree that certain kinds of fine wine, certain kinds of luxury watches, and certain kinds of fine jewelry are good stores of wealth, but those areas of the market are fraught with peril. Let's say you put $1 million into fine wine. How the hell are you gonna do that?
I've bought a lot of nice wine over the years. It is not easy to find a good dealer, and how do you know that what you really have is Chateaux Margaux and not some kind of a gussied up chianti? It's very difficult. Now you say I went to a reputable auction house, I did blah, blah, blah. I got it. How are you gonna get your money out of it someday 20 years from now?
The answer is you gotta go to the same auction house. There's very high transaction costs. It's very difficult to prove the providence of the wine that you own. And worse of all you've got lots of ongoing costs and headaches of storing it. What happens if your chiller dies? What happens if the bottles spoil? I just think that for people who are not in the wine business that is a very high hurdle to entry. The jewelry and the watches I think is a lot easier.
So every Rolex has a serial number. There's a clear line of documentation from where you bought the watch, when it was made, all that stuff is recorded. I think that Rolex watches, Paddock watches in particular are very collectible and have a well proven record of being a safe store of value. I have to brag on myself if I can just once.
Country Club Guy: Please do. I'm used to it.
Porter Stansberry: I bought a very limited edition Paddock watch five years ago when it was first offered. Long story, but Tiffany and Paddock got together and opened a watch boutique in the Tiffany flagship store in New York, I think it's on the second floor. I bought a watch that commemorated the opening of that boutique, and they only made 100 of them. It's a Paddock watch, but it has the Tiffany brand on it as well, and you could only buy it at that boutique. There were only 100 made. I have the tenth watch.
Country Club Guy: Was there a minimum spend to get to be able to buy the watch?
Porter Stansberry: I was invited to buy the watch. I don't know how I got on that invite list.
Country Club Guy: I'm just trying to get our listeners into your world.
Porter Stansberry: I'm sure that the long relationship that I have had with Tiffany has something to do with me being invited to buy the watch. Anyways, that watch sold at auction last week. One of the original buyers of those 100 watches sold his at auction, I guess his estate sold it, and it had tripled in price.
Country Club Guy: Wow.
Porter Stansberry: But let me be clear about all of this. I said they're a good store of value. I do not believe that they're investments just like I don't believe that gold is an investment. I have a large collection of Tiffany jewelry. I have a large collection of Rolex watches. And I have a relatively nice collection of Paddock watches.
Country Club Guy: Does your apartment smell of mahogany, too?
Porter Stansberry: Sometimes, but it's not an apartment.
Country Club Guy: Oh sorry, that's your gun room. It's the size of an apartment.
Porter Stansberry: I enjoy owning these things because I think that they're beautiful and I admire them. The Tiffany jewelry collection in particular is just simply gorgeous and I love watching my wife wear the pieces. But in the back of my mind it is always I know what we own, I know what I paid for them, I know what they're worth, and it is another form of wealth. It's also a form of wealth that's much easier to pass on to my heirs.
Believe me, when I give my grandson a Rolex watch someday for graduating from high school or college or his wedding, the tax man is not gonna know anything about it. Of course I think you should fully comply with all tax laws and you should report all such gifts to the proper authorities. What I'm saying is if I chose not to follow the law it would be very difficult for the tax man to identify that. So I think these things mostly have a role in terms of asset protection and estate management. I do not think that they're investments.
Even though I've done very well with the things that I've bought, I don't think they're investments. Why are they not investments? Well, most of all because they do not have earnings or yield. An investment is something where you put your capital to work for you. My capital is not working for me in Rolex watches or in Tiffany jewelry. It's just being enjoyed by me and it's unlikely to go down in value. Sorry that was a very long-winded answer.
Country Club Guy: No, it's a great answer.
Porter Stansberry: But I feel pretty strongly about that. I also think that people that really don't have any kind of substantial estate issue, I think they're mostly just fooling themselves when they think of these things as an investment, because trust me, the cheapest Rolex watches are not the ones that go up in price.
Country Club Guy: And if they do it's marginally. It's maybe $500.00, is that an investment?
Porter Stansberry: No.
Country Club Guy: Probably not.
Porter Stansberry: And when you have to sell that watch it's probably gonna be because you're getting a divorce and you need to pay for a retainer for a lawyer, and I'm not kidding, that's where all the Rolexes on the market come from. They all come from divorces. Believe me, the pawn shop is not gonna give you deal on it. You're not gonna make money on it. What did they say in Trading Places?
Country Club Guy: About the watch? "This watch tells time in seven different time zones."
Porter Stansberry: "This watch tells time."
Country Club Guy: "I bought it for $3,000.00." "In Philadelphia it's worth $50.00."
Porter Stansberry: If you go try to pawn a lower end Rolex, a Sub Mariner or an Explorer II or a Steel, you're not gonna get $1,000.00 for it.
Country Club Guy: What do you think Left Lane gets for his fake Rolexes online?
Porter Stansberry: Well, he gets nothing when you throw them into the harbor at Ocean City.
Country Club Guy: Please email, [email protected] and I'll tell you a story.
Porter Stansberry: So listen, if you guys have a different opinion about your watches or your jewelry I'd love to hear it. My friend Sjuggerud collects rare guitars. You gotta collect something that you can prove the providence of and that you have a passion for and you know a lot about, and buying the cheapest version of it is not the way to go. You wanna buy the limited, the most exclusive.
So all the Tiffany jewelry that I've bought my wife, none of it was from the Tiffany jewelry store. It was all out of the blue book. It's all one-of-a-kind pieces that were custom made by Tiffany and that are sold to collectors like me. And as you know, the really beautiful pieces I bought her she won't even wear.
Country Club Guy: No. They don't go with yoga outfits.
Porter Stansberry: But I still love having it and it is really beautiful art to own, and of course we own a lot of art on the wall, too, paintings and stuff, but I don't know as much about paintings as I know about jewelry and watches.
Country Club Guy: Yeah. That's not your forte.
Porter Stansberry: And Ferraris. By the way, you saw a Ferrari sold for $45 million last week.
Country Club Guy: Let me guess, it was a '63?
Porter Stansberry: It was a '63 250 GTO.
Country Club Guy: Where there was like one or two left in the world something like that.
Porter Stansberry: Yep. Very rare, very high quality, very expensive. It was last purchased for I think $10 million.
Country Club Guy: Tyler P., if you can afford that, that's a good investment.
Porter Stansberry: Yeah. I think actually Ferraris are fantastic investments.
Country Club Guy: I agree. Well, that concludes this week.
Porter Stansberry: See, I just contradicted myself. They're not investments.
Country Club Guy: It's fun. It's a good hobby.
Porter Stansberry: They're a fantastic store of value.
Country Club Guy: Right. Are we finished?
Porter Stansberry: I think we're done.
Country Club Guy: All right. You can check out the transcripts. We get a lot of emails on transcripts. People don't like to listen, they like to read.
Porter Stansberry: I can't imagine anything more boring than reading our transcripts.
Country Club Guy: I know. Go to InvestorHour.com. All the transcripts are there. Justin, make sure they're on there this week – it was not there last week – or you're fired. But that's it for this week, Porter. What do we say?
Porter Stansberry: Love us or hate us, just don't ignore us.
Country Club Guy: Buck will be back next week. We'll see you then.
Porter Stansberry: Bye, everybody.
Announcer: Thank you for listening to the Stansberry Investor Hour. To access today's notes and receive notice of upcoming episodes, go to investorhour.com and enter your email. Have a question for Porter and Buck? Send them an email at [email protected] If we use your question on air, we'll send you one of our studio mugs.
This broadcast is provided for entertainment purposes only and should not be considered personalized investment advice. Trading stocks and all other financial instruments involves risk. You should not make any investment decision based solely on what you hear. Stansberry Investor Hour is produced by Stansberry Research and is copyrighted by the Stansberry Radio Network.
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