Business

Michael Lewitt – China, Oil Prices & The Credit Bubble: This Is Not A Drill

China, Oil Prices & The Credit Bubble: This Is Not A Drill

“Life invests itself with inevitable conditions, which the unwise seek to dodge, which one and another brags that he does not know, that they do not touch him; but the brag is on his lips, the conditions are in his soul. If he escapes them in one part they attack him in another more vital part. If he has escaped them in form and in the appearance, it is because he has resisted his life and fled from himself, and the retribution is so much death.” – Ralph Waldo Emerson, “Compensation”

Last October, when I told readers of Sure Money (http://suremoneyinvestor.com) that the stock of Valeant Pharmaceuticals International Inc. (VRX) would hit $100 (it was trading at $170 at the time), I certainly didn’t expect the stock to hit my target two days later – but that’s exactly what happened. Sometimes it’s better to be lucky than smart. Readers who took my advice and bought puts were ecstatic.

Similarly, I didn’t expect the S&P 500 to hit my year-end 2016 target of 1900 in the first month of the year, but it appears that things are moving in that direction. While my calls are always more directional in nature than anything else, they raise the question of what happens if the market drops more quickly than expected. Most stocks were already in a bear market by the end of 2015; it was only a matter of time before the cap-weighted indices joined them. The average stock on the S&P 500 is now down 20% from its 52-week high. The market is telling us that the narratives of economic strength being promulgated by Wall Street, the mainstream financial media and the Obama administration are flat-out wrong.

Investors need to learn to ignore what they are told by the establishment and think for themselves. The same government that wants to deny that radical Islamic terrorists seek to destroy us is telling people that the U.S. economy is strong. The same Chinese government that backs Iran and actively undermines American interests around the world claims its economy is growing at high single digit rates while electricity production, commodity prices and other data tell a much darker story. And a Federal Reserve that creates bubble after bubble while issuing forecasts that make weathermen look like Nostradamus tells us the economy is so strong that it plans to raise interest rates four more times in 2016 while commodity prices plunge, 96 million people can’t find work, and it could barely bring itself to squeeze a 25 basis point hike out of its tightly clenched loins after seven years. Anyone who believes a word that any of these people say is, not to put too fine a point on it, a fool.

To repeat what I have written before, here is where thing stand from where I sit:

  • Oil prices will soon head into the $20s and take a long time to recover.
  • Low oil price are bad for the economy.1
  • Actual inflation is much higher than reported by the government.
  • S&P 500 earnings estimates for 2016 are too high.
  • The S&P 500 will drop significantly in 2016 (beyond what has already happened).
  • The high yield bond market will not bottom until late 2017 or 2018.
  • The Fed will not raise rates by more than 25 basis points in 2016 (if at all).
  • Treasury yields will drop and the yield curve will flatten.

Most important, as I first wrote more than a year ago, it will not require a recession or an aggressive Fed tightening to cause a bear market at the zero bound; the bear market has already begun. Traditional rules and conventional thinking no longer apply after seven years of zero rates and several bouts of quantitative easing. This is what markets told us in 2015 as many if not a majority of stocks entered a bear market without the onset of a recession or any sign that the Fed will move aggressively to raise interest rates. In fact, the Fed had to be dragged kicking and screaming to raise rates by 25 basis points when it was too late for it to do any good and probably did damage. The most likely next step is for the Fed to retract that interest rate hike and initiate another round of quantitative easing as markets and the economy weakens, not because that would be good policy (it would not) but because that is the only way the Fed knows how to operate. It veers from error to error in a world that it either doesn’t understand or, if you are cynical, doesn’t want to understand because it realizes that the only way it can try to keep the fraudulent Ponzi scheme known as the global economy aloft is to keep printing money until the entire system blows up.

Right now, investors appear to be most worried about China. China is devaluing its currency and its stock market is collapsing.2 China is an object lesson in what happens when a country keeps printing money without any regard to the consequences until its economy simply collapses under its own weight. Regardless of what China’s phony official statistics tell us, the country is no longer growing – it is imploding under a debt load that exploded from $7 trillion in 2007 to more than $30 trillion today. The country is an environmental disaster filled with ghost cities, mines producing too much of every commodity known to man, and hundreds of millions of peasants that it somehow thinks it can transplant into cities and turn into productive urban citizens by saying abracadabra and willing it to happen. The fact that Western observers actually believed that the Chinese miracle was anything other than an impossible experiment that had any chance of succeeding without causing major global financial instability is a testament to the ability of intellectuals to convince people to ignore common sense and the lessons of history. China may eventually transform its economy into some version of capitalism, but it isn’t going to do so in a matter of decades and certainly won’t do so without severe social, economic, environmental and likely global disruption. Anyone who believes otherwise knows little of history and humanity.

So rather than stand agape at the prospect of a grossly inflated and fraudulent Chinese stock market blowing up in their faces, investors should wake up to the reality that the world has a serious problem on its hands. The only thing stopping the Chinese stock market from vaporizing is the Chinese government stepping in and buying up the shares of its thousands of worthless companies and propping up the rest of the fraudulent enterprises that populate the country. But the ability of China’s government to do so is limited. China has massive bad debt problem that is only growing worse by the day; propping up the stock market is not going to make it better and $3.3 trillion of reserves (which are shrinking by the day) wouldn’t be enough even if the problem could be solved by the government bailing everybody out. China’s reserves are shrinking rapidly as its sells Treasuries to prop up its economy, which is why Treasury yields haven’t dropped as much as one would expect during the stock sell-off. Anyone that believes that China is going to miraculously stabilize is deluding himself; the country is at the beginning of a severe financial crisis that began in mid-2014 and triggered the global commodities collapse that infected the U.S. stock and high yield bond markets. It is only going to get worse.

Just as the pre-crisis world experienced a U.S.-based housing crisis that spread to the rest of the world through the “magic” of securitization and almost sunk the global financial system, the post-crisis world is suffering from a China-based commodities crisis that spread throughout the world and is now causing severe pressure on the global economy and financial markets. The only question is whether this commodities crisis will trigger a mere market correction and recession or something much worse. In view of the fact that the post-crisis world is far more leveraged and geopolitically fractured than the pre-crisis world, there is a serious chance that the world is in store for a crisis rather than something less severe.Investors should prepare accordingly. That means they should sell their  stocks and move to cash until markets stabilize, buy gold, and figure out which party in the upcoming presidential election is serious about setting the United States on a productive economic and foreign policy course.

Some credit-related stocks that I am focusing on now are the publicly-traded private equity firms (BX, KKR, APO, ARES, CG, and FIG), which are off 40-50% from their 52-week highs. These stocks are likely headed significantly lower as the credit cycle continues to deteriorate. Buying these stocks at the bottom of the last cycle proved to be enormously profitable and will likely be a good move again, but I would wait for them to drop by another 30-40% as I expect them to do.

The stocks of the business development companies (BDCs) are all trading at discounts to their net asset values. BDCs make loans to small and mid-sized companies, many of whom are owned by private equity firms. For the most part, these companies are at the lowest tier of the credit spectrum. This sector will experience serious problems as the economy remains sluggish and their cost of capital rises as the credit cycle deteriorates. Investors should not be tempted by the high yields these companies offer because their net asset values are likely to continue to deteriorate. In particular, Prospect Capital Corp. (PSEC) is a BDC that charges egregious fees to its shareholders while its stock has performed poorly and should be avoided.

We are in the early innings of the unwinding of the largest credit bubble in history. As Emerson warned in an essay that remains one of the great meditations on the economic adage that “there are no free lunches, “Cause and effect, means and ends, seed and fruit, cannot be severed; for the effect already blooms in the cause, the end preexists in the means, the fruit in the seed.” This fruit is rotting. Denial is not a strategy. This is not a drill.

Michael E. Lewitt

mlewitt@thecreditstrategist.com

China, Oil Prices & The Credit Bubble: This Is Not A Drill by Michael E. Lewitt, The Credit Strategist

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