Archive for December, 2015
If you want to thank someone for the year-end stock market rally, thank the junk bond market.
Just don’t fall in love with stocks as they’re rallying… because the help they’re getting from the junk bond market won’t last.
In fact, stocks will likely be headed back down in first quarter of 2016 when the junk bond market resumes its ugly selloff.
Here’s what’s going on with junk bonds, why stocks are rallying, and why momentary calm in the junk bond market will give way to a storm that’s going to take stocks back to their August 2015 lows… and possibly a lot lower.
And when that happens, we’ll be ready. Because I’ve got the perfect way to play it.
Let’s get started…
The Fall in Junk Bonds Sent Billions into Stocks
A brief rally took junk bond prices higher in early November, but when the brief rally in oil reversed, junk bonds fell too, hitting new lows in early December.
On December 9, 2015, the Third Avenue Focused Credit Fund, a mutual fund loaded with junk bonds, announced it was suspending investor redemptions and would be selling its portfolio and closing the fund.
That got the world’s attention focused on what was happening in the junk bond market.
The Third Avenue fund had invested in illiquid high-yielding bonds, and as the market for junk bonds hit the skids starting in June, the fund didn’t have enough liquid positions it could sell in the open market to meet investor redemption requests.
Third Avenue, a distressed bond-focused fund company that opened its doors in 1974 and was considered one of the best high-yield mutual bond fund managers in the business, ended up with a portfolio of bonds they couldn’t easily sell.
According to Moody’s, high-yield bond issuances total more than $1.8 trillion today, about double the $994 billion outstanding at the end of 2008. And Third Avenue couldn’t exit their positions in an orderly fashion in such a huge market.
Investors have been fleeing junk bonds in droves. The first week of December saw $3.8 billion exiting high-yield bond funds. According to Bank of America Merrill Lynch, that’s the biggest outflow in a week in the last 15 weeks. On top of that, more than $500 million exited leveraged bank-loan funds in the same week.
Most of the money exiting junk bonds has been flooding into money market funds. Bank of America Merrill Lynch recently reported $212 billion flowed into money market funds in the second half of 2015, with $48 billion coming in during the last four months and $27 billion of that coming out of bonds.
So, you can thank the selloff in bonds for the more than $31 billion that subsequently moved into stocks over that same period, which looks like it will continue through the last days of 2015.
That’s where the money’s coming from that’s fueling this late year-end stock market rally.
But then what?
A Junk-Bond Collapse Could Set Off a Financial Panic
In its December 15, 2015, report, the Treasury Department’s Office of Financial Research Director Richard Berner said, “We see elevated and rising credit risks in U.S. non-financial business and in emerging-market economies, the continued reach for yield in a climate of persistently low interest rates, and the uneven resilience of the financial system.”
The report points to “high levels of leverage” and while noting that credit remained resilient, except for issuers of junk bonds and the energy and commodities industries, “resilience could be short-lived as creditors reconsider their exposure to those markets.”
What’s most disconcerting in the report is its assertion that:
The combination of higher corporate leverage, slower global growth and inflation, a stronger dollar, and the plunge in commodity prices is pressuring corporate earnings and weakening the debt-service capacity of many U.S. and emerging market borrowers. A shock that significantly further impairs U.S. corporate or emerging market credit quality could potentially threaten U.S. financial stability.
In other words, a shock – like, say, a further plunge in high-yield bonds – could set off a financial panic.
Junk bonds are facing their first down year since 2008. Year to date, the highest-rated junk bonds are down more than 5%, while CCC-rated bonds are down 13% on the year.
With energy related junk bonds comprising more than 20% of U.S. domestic high-yield issuance, any further drop in oil prices will hit a large part of the total market hard.
As 2016 unfolds, most of the hedges put in place by oil and gas issuers will expire, exposing them to falling oil prices and further weakening their cash flow positions and ability to service their high interest debts. A precipitous drop in oil prices would likely trigger a rush out of energy-related junk bonds before most hedges expire by mid-summer.
A panic in the energy-related junk sector will force high-yield bond holders, especially mutual funds and ETF sponsors, to sell their more liquid positions, depressing them, as they attempt to cash up to meet expected redemption requests.
What happened to Third Avenue, in other words, could be a coming attraction for a horror movie we’re not prepared for.
How to Play the Coming Junk Bond Collapse
If high-yield bonds break in 2016, which is likely, the best way to make money is to short high-yield ETFs like the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca:HYG).
While it’s currently enjoying a quick bounce after reaching 52-week lows of $78.21, HYG could easily drop another 25% to test the lows it saw back in 2009, just above $60.
To be safe, an investor could short HYG anywhere around its present level and use a 10% stop-loss to cover their short if oil rises and junk bonds rally in relief.
More aggressive investors who want to bet that junk bonds will continue to get hit in 2016 might want to buy longer-term puts on HYG that expire after mid-summer, when most of the oil hedges energy-related companies have on expire, exposing them to big losses if oil prices stay below $35.
When junk bonds start slipping again, stock investors will panic over the fact that the year-end rally won’t have taken markets above any of the resistance levels they’ve struggled to break through in the second half of 2015.
And if credit conditions are deteriorating in the speculative end of the bond market, stock speculators will start taking their profits and go to the sidelines before the exit doors there get too crowded.
In addition to shorting the high-yield bond market, I’m also preparing my paid subscribers for that eventuality… which will be unfolding sooner than most investors realize.
I love hearing from you, and I assume you like hearing from me.
So in honor of the holiday season, here’s a “grab bag” of some reader questions on my recent articles. I had fun answering them – please keep them coming!
First up, here are some questions people had after reading “The Hidden Impact of the Fed’s Impending Rate Hike… and How to Profit“:
Q: Will you please tell me what ETFs I can use when the markets go down?
~ Tony D.
A: When I’m bearish and want to bet stocks are headed lower, I generally like buying inverse ETFs based on the major market indexes.
ProShares Short Dow 30 (NYSEArca:DOG) for the Dow Jones Industrial Average, ProShares Short S&P 500 (NYSEArca:SH) to short the S&P 500, and ProShares Short QQQ (NYSEArca:PSQ) to bet the Nasdaq is headed lower.
If I’m extremely bearish, and I believe stocks are going to fall hard today or tomorrow, I’ll sometimes buy a leveraged short inverse ETF like the ProShares UltraPro Short S&P 500 (NYSEArca:SPXU). SPXU is a 3X-leveraged inverse ETF. That means if the S&P 500 goes down 1% today, SPXU would go up 3% today.
But leveraged ETFs are only meant as short-term trading vehicles. That’s why I said “if I believe stocks are going to fall hard today or tomorrow.” Because of the way leveraged ETFs are priced, they’re “re-set” every day – they’re not good long holds. In a perfect world, if you are right and you buy a leveraged inverse ETF and stocks go down right away, and they keep going down for multiple days in succession, you’ll be a very happy camper.
I’m not greedy. If I have a straight run for a few days holding an inverse leveraged ETF, I’d take my profits as soon as I think the selloff is over. I wouldn’t wait another day, I’d ring the register and be happy. If I own an unleveraged inverse ETF like DOG, SH, or PSQ, I’d probably use a 5%-10% stop to get out if the markets rallied. If you take small losses, you can get out and figure out where stocks are going and get back in if your timing was off but you think they’re going down again.
Q: What leveraged ETFs do you think are best when gold bottoms?
~ Mark J.
A: There are lots of leveraged gold ETFs. Here’s a good list to check out. Just remember what I said about holding any leveraged ETF, they’re very short-term trading vehicles.
Another way to “leverage” gold on the upside (betting bullion is going higher) is to buy miners. Mining stocks move up a lot faster than gold itself in an up-trending gold market.
Q: What are the best ETFs I can use when the euro goes down?
~ Sam P.
A: Don’t forget, you can’t just short one currency… all currencies are “priced” in terms of another currency. They always trade as a “pair.” If you think the euro is going down relative the U.S. dollar, you can actually sell short the CurrencyShares Euro ETF (NYSEArca:FXE). If you want a leveraged (2X) way to bet the euro is going down relative to the U.S. dollar, you can buy a popular inverse leveraged euro/dollar ETF, the ProShares UltraShort Euro (NYSEArca:EUO).
Q: Why not TVIX? It seemed to outshine everything in the last credit crisis.
~ Oscar S.
I’ve got nothing against VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca:TVIX), if you get into it and the move you expect, a dramatic drop in prices and a spike in volatility, happens right away.
Here’s the problem with TVIX.
It’s a leveraged ETF – so if you don’t get a sustained move down pretty soon after you buy it, and you sit with it a few weeks, or worse, a few months, it loses its value quickly. Bottom-line, it’s a leveraged ETF and great if you get the timing right, get in and get a sustained move in your direction.
Q: I´ve been buying VXX, and I´d like to know how you would split the amount you´d wish to invest between VXX and your present protection alternatives.
Also, what would be the most convenient EEM and DBB options prices to choose?
~ Henry R.
A: I’m not a huge fan of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca:VXX) because it’s based on VIX futures. VXX is thought of as an ETF (which it isn’t, and I’ll get to that), so understand that as an “ETF” it has its own supply and demand dynamics and its own bid-ask spread dynamics. But it’s based on two sets of futures that have their own “valuation” dynamics based on rolling first- and second-month futures contracts.
Furthermore, VXX isn’t an ETF, it’s an ETN (which is a note, not a fund, meaning what you think of as an ETF is actually a derivative), which adds up to a lot of moving parts and is hard to arbitrage and “value” properly.
But if you’re going to use VXX, I’d suggest you add a one-quarter dose of it to whatever other protection you have on. Just keep in mind, if markets settle down and stocks flatten out and go sideways, the VIX and VXX will drop a lot quicker than non-leveraged inverse ETFs you might have on for protection. My favorite way to play a spike in volatility is to buy calls on the actual VIX.
When I’m playing options I generally like to buy options three to six months out. I always prefer further out options because it gives me more time, but you have to weigh the time against the higher price or premium you have to pay for them.
That’s why I look at three to six months out and incorporate how much volatility I expect over that three to six months. If I expect a spike in volatility sooner rather than later, I’d opt for the cheaper, near-term options. If I run out of time but I still think I’m right, I’ll roll into the next three-month out options.
In a perfect world, if you KNEW the move you expected was going to happen in a couple of weeks and last a week or two, you wouldn’t waste money buying further out options and pay for time you wouldn’t need. But it’s not a perfect world and I’m very often right, but I can get stung because my options expire and I hesitate rolling out to the next few months and get sick when the move I expected all of a sudden happens and I’m not in the trade.
Here are a few questions readers had about “What the NYSE Isn’t Saying About Its Earth-Shattering Decision“:
Q: Why not just use a stop-loss/stop-limit order instead of just a stop-loss order? Set the stop-loss price at, say, $50.00 and the stop-limit price at, say, $48.50. If the price drop blows through $50.00, you don’t sell if goes below $48.50. My broker allows this. Doesn’t everybody set stop-loss orders this way?
~ Mike D.
A: That’s fine IF the stock doesn’t fall way below your limit. What if it drops to $45, or $40, or $30 and you’re not out? What if the stock doesn’t recover?
The problem with a limit is you may not get filled there and experience a greater loss because you’re not out. Then you have to deal with that additional pain, which is where a lot of people get into trouble.
Too often people lose more than they expected and figure they’ll hold on because the stock “has to bounce at some point” and it may not. Of course, it may bounce. But the problem is sitting on a losing position for a long, sometimes LONG time. Think about all the trades and money you could have made if you had that capital available.
Q: Shah, I’m close to retirement and most of my savings are in “401k land.” With everything that’s been happening, I’m ready to move to all gold and silver shares in my 401k. Am I wrong?
~ Susan S.
A: While I can’t give any personal advice here, I can say that we all will make a LOT more money in stocks than we ever will by buying just gold. Gold hasn’t done anything lately, so why put all your eggs in that kind of a basket? Gold isn’t what it used to be. Sure, it could have a nice move (but I’m not waiting for that to happen because I have no idea when or if that will ever happen) but so can a LOT of different stocks.
I’d never put all my eggs in one basket.
The bare, naked truth is that investment-wise, the best way to make money these days, and for the foreseeable future, is by being in the stock market. That doesn’t mean just buy and hold. That means hedge when you should (yes it may cost you, but so what, you pay for insurance that you don’t need until you really need it, don’t you?) and learn to play the market when it goes down.
If you aren’t that kind of investor, learn how to look at the market that way. Learn how to put on defensive positions using inverse ETFs, for example. By becoming more and more comfortable with increasingly volatile markets you can learn to make money on the way up and on the way down and “hedge” the positions you don’t sell and want to keep, hopefully because they are go-to, all-world companies that pay a really good dividend.
And finally, here’s a short and sweet question about “The one firm trying to keep your trades safe from the ‘Flash Boys.’“
Q: Can a small investor utilize IEX at the present time?
~ George N.
A: No, not at this time. Your broker-dealer may be a member and it’s possible they could let you trade through IEX, but the way IEX is set up now (like a dark pool, but a fair one), I doubt a small investor would trade enough size for their broker-dealer (brokerage) firm to get them direct access.
I’m sure they’re working on it, because we should all have access to trade on a level playing field. I’ll call Brad and ask him what his plans are for helping “small investors” and follow up with you here.
That’s all, folks.
Hope you have a great holiday.
Gas prices are at a record low and markets continue to rally. What could go wrong? Plenty, it turns out.
In his latest interview on “Varney & Co,.” Shah explains why the combination of falling oil and a rising Dow could spell a disastrous 20% drop by Q1 2016. Then he offers insight into whether or not oil dividends are safe – and comments on Apple’s surprising drop and McDonalds’ even more surprising rally.
And as a post-debate bonus, he clues viewers in on the Republican candidate whose fiscal policy he likes best.. It might not be the one you’d expect!
I’m always talking about “Disruptors”…what’s good and bad about them… and how you can make money from what I call “Disruptonomics.”
Disruptonomics is the science of how monumental shifts in everything around us changes our lives. These Disruptors send huge Capital Waves into new paradigm businesses and push big Capital Waves out of adversely disrupted businesses.
Marketplace lending is a perfect example of a Disruptor business.
I’ve written beforeabout the issues marketplace lenders were going to have and how you’d be better off borrowing from a marketplace lending site than investing in any of them.
I don’t want to say “I told you so,” but I’m being proved right yet again.
Things aren’t getting better for investors in what used to be called “peer-2-peer” lending.
So, if you want to get an online loan, go for it – but don’t waste your money betting on any of the sites being a home-run investment.
For now, you should keep your capital away from marketplace lenders.
P2P Lenders Aren’t Actually Independent
First of all, peer-2-peer lenders aren’t banks.
They’re disruptors precisely because they aren’t banks, but act like banks.
But just because marketplace lenders aren’t banks doesn’t mean they’re immune from banking regulations. That’s because marketplace lenders have bank “partners.”
The disruptive side of P2P lenders is upfront. It’s in where borrowers go, which is online. It’s in how borrower’s creditworthiness is profiled, which is largely based on online access to things like payment histories and social media profiles. And upfront it looks like a borrower is borrowing from an online “peer.”
That’s upfront stuff. The back end of P2P lending is still about banks.
Disruptive P2P lenders need a bank to operate. And that’s becoming a problem
The Dark Side of “Conduit Banks”
You see, P2P lending sites don’t make loans. They are simply an online introduction conduit. They’re matching rooms where borrowers and lenders “speed date.”
When a lender agrees to fund a borrower’s loan request online, the actual loan runs through a bank, usually a very small bank, more often than not located in Utah.
Why Utah? Because Utah doesn’t have state usury limits or rate caps like other state-chartered banks have.
Tiny Utah-chartered WebBank is the backend bank of several marketplace lenders, including Lending Club (LC) and Prosper, two of the largest and best known P2P lending sites.
WebBank acts as the lending bank to the borrower, where WebBank uses the lending “peer’s” capital as collateral. If the borrower doesn’t pay, WebBank has the peer’s capital and isn’t at risk.
But conduit banks are coming under increasing scrutiny – as are lending sites themselves – with regard to cutting regulatory corners on customer information, antiterrorism and anti-money laundering regulations.
American-born terrorist Syed Rizwen Farook – just weeks before he and his wife, Pakistani-native Tashfeen Malik, murdered 14 people in San Bernardino, California – got a $28,500 loan through Prosper.
That loan was subsequently sold to Citigroup, which intended to package it into an asset-backed security to be sold to investors.
The California Department of Business Oversight is now looking into Prosper, Lending Club, and twelve other marketplace lenders doing business in California.
The U.S. Justice Department is also looking into marketplace lenders, as are state and federal bank regulators.
On top of those inquiries, the U.S. Treasury is looking into conduit banks to see if they are being used to facilitate terrorist financing or money laundering.
Regulatory pressures are taking an increasing toll on lending sites. Publicly traded Lending Club’s stock, which I panned in an earlier article here, is trading near 52-week lows and will likely remain under pressure as lending businesses face more scrutiny.
Investors Who Lend through P2P Sites Are At Risk, Too
Besides not wanting to be an investor right now in these P2P lending businesses, it’s not a good time to be a lender on the sites.
Citicorp will no doubt be scrutinized for buying the Rizwan Farook loan from Prosper, as will other big bank “lenders” who have essentially replaced what used to be “peer” lenders on most of the big marketplace sites.
And small investors who manage to lend to high-interest-paying borrowers through marketplace sites might want to take another look at how at-risk they are.
After all, they’re lending to borrowers who are mostly consolidating high-interest loans, which are likely to go higher if the Fed raises rates, as the economy muddles along amidst increasing global strains, geopolitical and domestic uncertainties.
All in all, it’s not a good picture.
That’s why I say you’re better off taking advantage of these marketplace Disruptors by borrowing from them rather investing in them.
And you can say I told you so.
P.S. – I’ve been tracking a new “disruptor” for the last few months, and I’m finally ready to share it with you. It’s a breakthrough in the healthcare sector that’s poised to revolutionize the diagnosis and treatment of the eight deadliest diseases that afflict people over the age of 55. The world’s top scientists are calling it the “Holy Grail”… and I’ve identified a tiny small-cap company that’s about to transform this modest $100 million industry into a $30 billion mega-boom… Click here to learn more.
While Shah allows that the markets could very well rally into year-end, he’s convinced that the selloff – the real selloff – hasn’t even begun yet.
If markets do in fact rally (with Santa’s help), January could get ugly. The big-cap leaders could still drag the markets higher, but there’s nothing underneath to sustain a real rally.
Shah weighs in on a possible merger of EI du Pont de Nemours and Co. (NYSE:DD) and The Dow Chemical Co. (NYSE:DOW) – and why we shouldn’t care about this overblown bit of financial engineering. He also comments on the recent surge by Smith & Wesson Holding Corp. (Nasdaq:SWHC) – and where he expects the stock to go from here.
Everyone – from the suits on Wall Street and the pundits on television to individual retail investors – is talking about the Federal Reserve raising interest rates for the first time since 2006 – and what’s going to happen to stocks, bonds, and commodities here in the United States.
There’s a lot of noise out there, and it’s difficult to separate the valuable, useful information from the nonsense.
Today, I’m going to tell you exactly what’s going to happen with interest rates, and what it’s going to do to stocks, bonds, and commodities.
But there’s hidden impact to the Fed’s impending interest rate hike that people aren’t talking about. I’ll tell you about that, too.
And, of course, I’ll show you what you can do to protect yourself – and make money from what everyone else is so afraid of.
Here’s what’s happening…
A New York Stock Exchange (NYSE) Trader Update dated November 16, 2015, abruptly announced:
Subject to effectiveness of a rule filing with the SEC, NYSE and NYSE MKT will no longer accept new Stop Orders and Good Till Cancelled (“GTC”) Orders beginning February 26, 2016. Additionally, all existing GTC and Stop Orders residing on the NYSE book will be cancelled.
The NYSE ending GTC orders – which typically expire in 90 days anyway – isn’t a big deal because brokerages have their own in-house GTC orders investors can still employ.
And brokerages will still offer stop-loss orders. The only difference will be they’ll get triggered in-house and then sent as a limit or market order to be executed.
Since investors can still place stop orders and GTC orders with brokerages, the NYSE saying it would no-longer accept stop orders doesn’t appear to be earth-shattering.
But it is. Let me tell you why…
The only explanation for the Exchange’s rule change came from an unnamed NYSE spokeswoman whose email response to inquiries was:
Many retail investors use stop orders as a potential method of protection, but don’t fully understand the risk profile associated with the order type. We expect our elimination of stop orders will help raise awareness around the potential risks during volatile trading.
What the NYSE (which is regulated by the Securities and Exchange Commission and has to have all its rules approved by the SEC), isn’t saying is that with the approval of their regulator, they’re ending two order types investors have used on the Exchange to limit their losses for over 100 years.
And they’re doing it because the public face of trading, the venerable New York Stock Exchange, the stock market as we know it, is broken and they don’t want to take responsibility for what has happened and what is going to happen.
In other words, because the SEC has lost control of stock market trading on the venues it regulates, it is passing responsibility for investor losses along to brokerage houses and, ultimately, to individual investors themselves.
Stop-loss orders are mostly used by investors who aren’t able or willing to watch the market all the time. By putting down a stop order, an investor would could “stop the loss” on a position if the price of his stock fell to a predetermined level.
A stop order becomes a “market” order when the stop-loss price is reached.
For example, if you own a stock at $50 and want to sell it by using a stop order if it falls to $45 (for a 10% loss), once the stock trades $45 your stop-order becomes a “market” order and your stock is sold at the next best price someone is willing to pay. You may sell stock at $45, or less, depending on where other buyers are bidding for your stock.
There used to be lots of “standing” orders left with NYSE specialists and Nasdaq market-makers, so when a stop order was triggered the seller could usually sell his stock at or just below where his stop order became a market order.
When there were lots of standing orders waiting to buy and sell shares, individual stocks and the market didn’t have the huge swings like they have today.
Buy orders could always get cancelled and a stock or the market could fall steeply. But buyers and sellers typically lined up to transact at prices considered fair and orderly.
That’s all changed.
How Bad Management Thins Market Liquidity
The U.S. has 14 stock exchanges and dozens of “dark pools.” And because competing trading venues need orders to create transactions, they “pay for order flow” from brokerage houses and institutional money managers. All that competition spreads orders far and wide. So there’s no singular exchange or place where hundreds or thousands of “standing” orders reside waiting to be executed.
By not properly managing competing trading venues and allowing unrestrained selling of order flow, the SEC aided and abetted the “thinning of liquidity.”
The minimum increment a stock can be traded in has also changed.
Up until 2001, stocks mostly traded in increments of an eighth of a dollar, or twelve and a half cents. Now, under “decimalization,” stocks trade in increments as small as a penny.
What seemed like a good idea to narrow spreads – the difference between the price someone is willing to pay for a stock and the price someone is willing to sell that stock for (which used to be $0.125 and can now be $0.01) – turned out to be another nail in the market’s coffin.
While decimalization theoretically reduced spreads and transaction costs, in practice what happened is investors didn’t leave their orders standing around because intermediaries (meaning specialists on the NYSE and Nasdaq market-makers) could take a small one-penny per-share risk and buy stock a penny ahead of a standing order they saw residing on their books.
By not correcting the mistake of moving to decimalization, the SEC allowed short-term traders to front-run standing orders and use those standing orders as a backstop to exit their trades if prices go the wrong way. That unfair treatment caused investors to leave fewer standing orders in the market, which aided and abetted the “thinning of liquidity.”
Of course the NYSE can’t say any of that.
All they can say is they won’t accept stop orders.
They should say it’s because market liquidity is so thin on big down days, thanks to what the SEC has allowed, that stop orders will get filled way below where they should.
And the NYSE and the SEC now want you to blame your brokerage house for that, or blame yourself for not being more aware of the risks inherent in stop orders.
How to Protect Your Profits Now
My advice is to keep using your stop loss orders as long as your brokerage lets you because using stop orders is smart.
Every empirical study ever done on using stop-loss orders and trailing stops demonstrates they can be incorporated in portfolio management to meaningfully enhance returns.
Just be aware: because of what the SEC allows to happen on their watch, you will get bad fills on your stop orders and you will get stopped out and watch your stock pop right back to some higher level after you’ve been screwed out of your position.
If you choose not to use stop orders, you need to watch the market and your stocks. You can do that by setting up “alerts” on your smartphone or computer to alert you when your positions hit a predetermined price.
And if you keep losing money because the market becomes increasingly volatile, or you’re on the sidelines not making any money because you’re afraid of what’s become of the stock market, send a letter to the SEC and tell them to fire themselves.
They really deserve it.