IS THERE BLOOD IN THE WATER? (STOCK MARKET CONDITIONS IN AUGUST 2015)

Today, the stock market had a very sizable drop. It lost 530 points on the DOW – putting it down to 16,459, and the question on everyone’s mind is: Is the Stock Market going to have a really big crash soon?

Well, like Stig and I have been saying, that’s really hard to forecast – we don’t know. This is what I do know.

I think cheap oil, the strong dollar, and the China crash are having an enormous impact on the world economy and a potential US equity crash. Right now, there isn’t blood in the streets. What I mean by that is, we aren’t seeing enormous amounts of defaults in the bond market. Now, if these cheap oil prices persist, you are going to start seeing that occur. Here’s why. In the last 5 years, oil companies have taken out enormous amounts of debt in order to purchase expensive equipment to stand-up all these oil fracking companies and oil related businesses. If oil stays at $40 a barrel and lower, some of these companies can’t make a profit. It costs some of them $50 – $60 dollars (conservatively) to simply break even. That means if oil stays low, those companies are going to start defaulting on their debt. Now here’s the thing; defaults don’t happen quickly. A lot of the times, companies can go into 2nd and 3rd rounds of funding to keep things afloat, or they can use retained earnings off their balance sheet. This could take 2 or 3 quarters to shake out. Now, don’t get me wrong, a stock market crash in the 3rd quarter 2015 is definitely a possibility, but what I guess I’m trying to say is this: I’m not seeing fundamental defaults that would cause the market to melt-down. I don’t see blood in the streets… today.

When defaults do not occur, money simply shifts from one asset class to another. For example, the sell-off in equities today was probably money flowing from equities into cash or bonds. This money can move all over the world, but until we start to see defaults, the money (or credit) doesn’t dry up and disappear. This is why I’m watching the default rates closely – particularly in the oil industry.

Now one of the main reasons I’ve been a bear since February (which I’m sure everyone has noticed on the podcast), is because I didn’t see any upside. With the dollar getting stronger by the day, how are US companies going to increase their top or bottom line? I argued they couldn’t (especially since May when China had it’s melt-down). So far that theory has been correct – I could still be proven wrong. Now, moving forward, equities are cheaper. That also means their yield is higher than it was back at 18,300. At 18,300, I’d argue the equity yield was 3.7 percent and at the current level of 16,459, the yield is now 4% or so. That’s not much of a difference, but it has increased the spread between fixed income and stocks. So I think this means equities are going to be all over the place until defaults start to occur. What I think you’re going to have is “traders” trying to chase the spread (4% in equities versus 2% in fixed income) until the defaults occur. For me, I’d rather sit back and watch the volatility eat the traders alive because there’s no way to predict what the next day holds (my opinion). Besides, I’m not in the business of chasing 2-4% yields on the upside with -40% or more risk on the down-side. That’s what I like to call a liquidity trap.

Here’s what I’m excited about. Until we see a major shift in asset prices (or a major pull back), I think oil is going to continue to get punished. These companies are in a death spiral trying to keep market share. Eventually some companies are going to default and get eaten up by the ones that can produce oil at the cheapest price. When that happens, and once the dust settles, I think the oversupply and under demand is going to shift and normalize. That means there might be big opportunities in the price of oil (the commodity). Oil is now below $40 a barrel, and the price to produce is going to be higher than that in the future – especially if supply and demand balance and fiat currencies devalue. I don’t know if we are at rock bottom yet, but it’s coming quickly and I’m excited about this approaching investment opportunity (it’ll be a 5 year or more play when I turn it on).

Considering the FED has no tools to fix a potential crash (according to the Wall Street Journal), we know they have to devalue the dollar. If that happens, gold has historically done really well during fiat currency devaluations. I know most value investors hate gold (man you can get into some heated debates on this one), but I feel inclined to mention the idea because you can’t argue with the facts: Gold and Silver do really well when domestic fiat currencies devalue in a large way. If you don’t like this idea, simply ignore it – please, no hate mail or lectures on intrinsic value.

~Preston