Unrestricted Investing

February’s Correction Was a Dress Rehearsal

Nick’s Note: Here in The Palm Beach Daily, we’re still bullish on the markets. And even though I think we’re at least a year away from a bear market, it could sneak up on us. It’s much easier to prepare for a bear market while the market is going up than after it’s started its descent.

That’s why I’m bringing you this essay from Bill Bonner Letter coauthor Dan Denning. His crash protection plan is worth following… And could save you and your family if things get really bad without warning.

In late January, I wrote to Bill Bonner Letter subscribers and warned that the stock market was an avalanche in the making. All it needed was a gunshot to set it off.

The gunshot went off seven trading days after we published. I’m talking about the “trigger” that led to a 10% correction in the S&P from an all-time high. It was the fastest such correction ever, according to Ryan Detrick of LPL Financial Research. The Dow’s 10% correction was the fourth-fastest since 1897.

If there’s one point I could make to you today, it’s this: You ain’t seen nothing yet.

A Dress Rehearsal

The kind of move Bill and I are expecting isn’t a correction. It’s a cyclical peak, the crumbling of a great mountain of leverage (margin debt). It’s a complete reset of the American financial system.

This is a system burdened by massive and unpayable public debts and governed by inept and corrupt policymakers. A system where phony quantitative easing (QE) money has pumped up stock values by no less than $10 trillion over the last 10 years. A system where sound money is a dead concept and cash is headed to the gallows.

A 10% correction is a small preview of how quickly something more severe could happen. The speed of the move proves how fragile the market is. There’s more where that came from.

Think of this as a dress rehearsal.

Not to beat a dead bull, but this correction was easy to see coming. And we’re not out of danger yet. If you look back at stocks in February, you see that all of the valuation metrics were off the charts. They still are. It’s why I told you the market was like an avalanche in search of a gunshot. That gunshot came on February 2 in the form of a report on rising wages.

The conventional wisdom is that the wage report stoked fears of higher inflation in 2018. Higher inflation would give the Federal Reserve wiggle room for three or even four small interest rate rises this year. Both stocks and bonds shuddered at the thought.

Yet, at writing, the Dow Jones Industrial Average is nearly back over 25,000. The market-cap-to-GDP ratio peaked on January 26 at 150.8%. Even after the correction, it stands at 144%. Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) is at 33.12, second only to the 44.19 level it reached in December 1999. Stocks are still expensive by historical standards. Very.

And margin debt hit $642.8 billion in December 2017, according to the Financial Industry Regulatory Authority (FINRA). I told readers of The Bill Bonner Letter back in August 2017 that total margin debt stood at $540 billion. But that was just for margin debt of NYSE member firms. The FINRA data includes other firms in addition to the NYSE.

The NYSE, incidentally, no longer keeps margin debt data on its website. But net margin debt, or margin debt as a percentage of the total market value of NYSE-listed stocks, hit 1.31% in December 2017. That was a new all-time record. The previous record was 1.27% in 2000, according to Goldman Sachs. The data goes back to 1980.

By the way, there are several versions of what’s called “the Buffett Indicator.” The one I prefer is dividing the market capitalization of the Wilshire 5000 ($28.3 trillion) by the most recent nominal GDP number from the Bureau of Economic Analysis ($19.3 trillion).Wilshire 5000 Market Cap

No matter which one you use, they all show markets being overvalued.

The Big One

They may be boring, but if you want to know where trouble is coming from you’re going to have to watch interest rates. The notes from the January 30–31 meeting of the Fed’s Monetary Policy Committee were perceived as “hawkish” by investors. By that I mean there was nothing in them to change the belief that the Fed could hike interest rates three or four times this year (presumably by a quarter point, or 25 basis points, each time).

Goldman Sachs reckons if the 10-year rate gets to 4.25% by the end of the year, stocks could fall by 25%. That’s an overly complicated way of saying that debt is a drag on growth. When credit growth slows and rates go up, debt gets more expensive (and outstanding debt gets more expensive to service).

If that sounds gloomy, the below chart from the Fed confirms it. The grey lines on the chart are recessions. You can see that nearly all of them are preceded by a cycle of rate raises by the Fed. We’ve had five quarter-point raises in the Fed funds rate since 2015. How many will it take to cause a recession?

Fed Interest Rate Changes

Definancialize Your Life

Now is a perfect time to start “definancializing” your life. That means reducing your exposure to an overly complicated financial system that, either because of outside attack or its sheer complexity, is prone to collapse.

The first thing to do is to review my asset allocation strategy. Bill and I are calling it the “new permanent portfolio.” It’s designed to prepare you for any scenario the markets can throw at you.

Also, check out the list below for five tips for preparing for an uncertain financial future. This isn’t strictly investment advice, but they’re all ways to help you prepare for what could be coming. I practice these habits in my own life, and I find myself all the better for it…

Five Steps to Preparing for an Uncertain Future

  • Defer consumption no matter what. Save more than you think you need to. It’s a good moral habit, too. When you defer consumption, you accumulate capital. You resist the urge to gratify every desire. As the Stoic philosophers would say, you free yourself from enslavement to your passions.
  • A little walking-around money. Carry enough cash on you each day to eat a meal, or get a cab ride over a long distance if you need to. You never know when the cash machines will break down or you might not be able to get back  home.
  • Cash insurance. Have enough accessible savings (in cash) to survive for six months if you lose your job or are ill. If this seems insurmountable now, see rule number one above. Americans have fallen into the dangerous habit of mistaking full grocery store shelves for wealth. We ARE a wealthy culture. But don’t live with “just-in-time” cash management.
  • Establish a family disaster recovery plan. Each of your family members should know how to contact one another in the event of an emergency which affects any or all of them. They should know important phone numbers, addresses, and, if necessary, the name of a family friend or lawyer to contact in a legal or medical emergency.
  • A “bug-out bag.” You may not have heard of a bug-out bag. And if you haven’t, it may sound a little crazy. But I can assure you it’s not as crazy as you think. Events that disrupt the routine of normal life across all of society rarely happen, even at the most extreme times in American history. But they DO happen.

The bug-out bag is just a reminder that in a real crisis, the value of your portfolio may be the least of your problems. Like the first-aid kit in your bathroom or the spare tire and road flare in your car… it’s the sort of thing you hope you don’t have to use… but shouldn’t be without…

A few things to get your bug-out bag started are…

  • A bag (obviously)
  • Identification
  • Cash
  • A first-aid kit
  • Contact names and addresses of friends and family
  • Food and water
  • Maps
  • A multi-tool
  • A change of clothes
  • Hygiene items (toothpaste, hand wipes, etc…)

Don’t wait for the bang. Use the market’s recovery to implement what we’ve suggested.

As I mentioned above, February’s correction was a dress rehearsal. The main event is yet to come…


Dan Denning
Coauthor, The Bill Bonner Letter


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