Final Act of the 'Super Bubble' [Free Preview]

Bonds, real estate, and stocks all face the risk of a massive draw-down. There aren’t many places to shelter. That's what happens when a bubble deflates.

Wednesday, September 7, 2022,

Chiswick, West London

By Tom Dyson, Investment Director

Greetings from London and welcome to new subscribers. I’m Tom Dyson, the Investment Director here at Bonner Private Research. As investment director, it’s my job to study all the economic research and data I can get my eyes on. Then I try to put the puzzle together and come up with an actionable investment strategy using publicly traded investments.

I publish my thoughts – and the latest update of our investment strategy – every Wednesday evening after the market closes. If you have any questions, please email me at bonnerprivateresearch@gmail.com. I’ll answer as many of your questions as I can at the end of each update, although please know I can’t provide any personal investment advice.

‘Every historical parallel suggests that the worst is yet to come.’

That’s from Jeremy Grantham, in his latest commentary (published last week) titled ‘Entering the Super Bubble’s Final Act'.’ Grantham has had a long and distinguished career forecasting the stock market. He correctly predicted the bursting of the Japanese bubble in 1989, the bursting of the tech bubble in 2000 and the busting of the subprime lending bubble in 2008. He also correctly predicted big stock market melt-ups in 2009 and 2018.

Here at Bonner Private Research, I’ve described the current stock market bubble as “the greatest speculative mania of all time, in all things.”  Grantham calls it a “superbubble” – only the 4th one in U.S. history. 

Like us, Grantham thinks it burst in January. He says the recent rebound we’ve witnessed in the major averages, which started in June and ended in August and retraced 58% of the initial crash, is a textbook bear market rally. The previous three superbubbles all featured similar bear market rallies after their initial crashes, too. 

From November 1929 to April 1930, the market rallied 46% and recovered 55% of its initial losses. In 1973, a summer rally recovered 59% of the crash’s initial losses. And in summer 2000, the Nasdaq recovered 60% of the crash’s initial losses.   

“Prepare for an epic finale,” says Grantham. “If history repeats, the play will once again be a tragedy.” 

Grantham expects the S&P 500 to fall at least 50% from current levels. I encourage all subscribers to read Grantham’s latest note in full (linked above) as it matches so beautifully with how we feel about the stock market here at Bonner Private Research.

A Gigantic Deflationary Crash

When the bear market started in 2000, I assumed the Fed would fight it tooth and nail. But frankly, I never imagined the bubble would last this long… or get so big. Over and over again, system managers resorted to ever more desperate measures to keep the bubble inflated and prevent the liquidation of bad debt.

We’ve had two giant systemic bailouts – in 2008 and 2020 – and 13 years of low interest rates and central bank money printing. Now 22 years later, the debt levels are bigger than ever and the stock, bond and housing markets are still wildly overvalued. See below Yale Professor Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio.

Source: multpl.com/shiller-pe

Now, Powell is invoking Paul Volcker and aggressively raising interest rates. I’m betting we’re about to see a gigantic deflationary crash, a cascade of debt liquidation, and a brutal bear market. It’ll end in a classic bottom where great stocks look like bargains. 

READER COMMENT:

I’m glad the Fed is fighting inflation by raising interest rates. As a retiree, I welcome the interest again and I wouldn’t mind a little deflation. I know it will be painful, but in the long run, we will all be better off. We’ve avoided our responsibilities for too long. It’s time to face the music.

MY RESPONSE:

Jerome Powell imagines himself in the mold of Volcker, defeating inflation. Powell has even invoked Volcker a few times in his speeches and comments this year. The problem with this idea is, when Volcker began hiking the interest rate in 1979, the government debt was $845 million... 32% of GDP. Today it’s $30 trillion… 122% of GDP. 

Source: US Federal Reserve

As we’ve said many times, this government is broke. Raising the interest rate with the government this indebted won’t fix inflation. It’ll just push the government closer to bankruptcy and precipitate a loss of confidence in the dollar, making prices seem even higher. It’s quite a pickle.

My advice: own plenty of gold and cash and stay well clear of the major stock market averages.

Set the dial to maximum safety mode. We suggest an asset allocation strategy of 30% stocks, 35% cash and 35% gold and other hard assets. If you’re a new reader, please consult our Strategy Report for a more in-depth explanation of how we arrived at these levels. We’re updating that report later this month. 

I spend most of my time looking for ideas you can put in your 30% stock allocation. But due to my overriding concern that we’re in a bear market, I’ve struggled to come up with stock ideas I consider safe enough to put on our Official List of tracked stocks. In a bear market, most stocks fall. And we’re in a bear market (with the largest liquidation phase yet to come). Above all, I’m not willing to take big risks or worse, blow a hole in our portfolios.

Midas Protection

The conventional wisdom is that gold is simply a protection against inflation. Not so. I buy gold on the thesis that the US government is broke and that ultimately this must be reflected by a falling dollar. So I buy gold as a hedge against currency debasement. My hope is, even as the dollar devalues, gold will at a minimum hold its purchasing power, as it always has. 

When someone says “the dollar’s up today” they’re usually talking about the dollar in terms of other paper currencies, like the pound, the euro or the peso. The dollar’s convertibility into other paper currencies isn’t what concerns me here. (Actually, the dollar is currently very strong against other paper currencies.)

It’s the future purchasing power of our savings in terms of rent, energy, transportation, food and services that concerns me. In these terms, it’s a virtual certainty that over the long term, the dollar’s value will decline. Gold protects against this decline.    

Another reason I buy gold is to protect my savings from declines in the prices of investment assets. This chart shows the Dow/Gold ratio over 120 years. It reveals the credit and investment cycle better than any other financial series I’ve seen. History tells us that at the bottom of the cycle, the ratio drops below 2 i.e. one ounce of gold almost equals one share of the Dow. At the top of the tech bubble in 1999, the ratio reached 44 to 1. Today, 22 years later, the Dow/Gold ratio is at 18, a decline of 59%. 

Over time, I see one ounce of gold being able to buy one share of the Dow… a ratio of 1. At what price will they meet? This is the trillion dollar question. No one knows the answer. 

But if you let me guess, I’d say they’d meet somewhere around 10,000.

My plan is to start selling gold and buying great companies when the ratio drops below 5. I don’t need to squeeze every last point from the ratio’s drop, so I won’t be trying to time the exact bottom of the market.

What if I’m wrong?

What if the Dow and the gold price don’t converge… or even worse, start to widen?

This is a great question and one I’ve pondered many times. The answer is, I’ll miss out on a bull market in stocks. Not a terrible outcome. I’ll be left behind by everyone else in terms of investment returns and I may experience some FOMO. But I won’t lose the family savings. And gold will continue to protect the purchasing power of my savings in terms of future purchasing power. 

On the other hand, we’ve been watching companies use historically low interest rates to rack up massive debt with which to buy back shares and maximize growth and the valuation of the company. Not to maximize profits. To maximize valuations, to which insider compensation is often tied.

The Dow/Gold ratio is telling you we are still in a regime where corporate CEOs are focused on valuation maximization. Until the debt is liquidated and the zombie companies shot in the head by the market, the stock market (or stocks as an asset class) are not a safe place for your money.

To be fair, they're never really safe. But if you're going to take the risk of buying stocks over bonds, or holding cash, you want to be rewarded for it...without exposing your capital to a 50% draw-down. The chance for a 20% gain from here is not attractive enough to risk losing 50% from here. 

So it’s really a simple question of probabilities.

That's the trouble with a Super Bubble. Bonds, real estate, and stocks all face the risk of a massive draw-down. There aren’t many places to shelter. That's what happens when a bubble deflates. Could I be wrong? Sure. But I still think I’m making the right bet, given the probabilities.

A study in debt

Wynn Resorts [WYNN] is an interesting debt bubble case study. Wynn owns a portfolio of highly-prized casinos in places like Macau, Boston and Las Vegas. In the right macroeconomic conditions, these casinos generate tremendous profits. Between 2017 and 2019, Wynn’s assets produced nearly a billion dollars a year in operating profits.  

But casino resorts are also a very competitive business and in order to build its world-class portfolio, Wynn had to borrow large amounts of money. It currently owes $12 billion in long term debt. 

Covid hammered the casino resort business. Macau is still struggling with Covid lock-downs and revenues there are way down from 2019 levels. Now we’re looking at an incoming recession and a decline in real estate values. Because of its massive debt load, Wynn won’t have any cushion to get it safely through the hard times that I think are coming. Here’s what I mean:

In its latest statements, Wynn reports $2 billion in cash and $8.5 billion in casino assets. In other words, when you subtract the $12 billion it owes creditors, it has a negative net worth of almost $1.5 billion.

(Accountants call a negative net worth in the corporate accounts a “stockholder deficit.”)

Wynn’s casinos lost $1.2 billion in 2020, $400 million in 2021 and $150 million in the first six months of 2022. On top of these losses, Wynn has to pay interest on its $12 billion in debt. Wynn is currently paying about $600 million a year in interest. So you can see, with such a giant interest bill, Wynn needs some kind of miracle if it’ll ever generate enough profits from its casino operations to show any retained earnings. 

Furthermore, Wynn financed itself at the lowest corporate interest rates in history. It must roll-over its entire debt load over the next seven years. We won’t know what interest rate Wynn will have to pay, but I think it’s fair to say Wynn’s interest expense will be significantly higher in 7 years than it is today. 

What would you pay for this business? To me, this looks like a business that is now totally owned by the bond holders. I don’t think the equity has any value at all, except maybe as a call option on some miraculous financial escape over the next ten years. The stock market, on the other hand, values Wynn’s equity at $6.6 billion, about half the value of Wynn’s debt. The way I see it, that $6.6 billion needs to take a 90% haircut… at least.  

QUESTION:

If what you discussed comes true, and I think it will, how much cash would you hold as a percentage of one's total portfolio? 

MY RESPONSE:

We’re suggesting a 35% cash allocation and a 35% gold allocation. From the letters I’ve received from subscribers, many of you are holding an even higher percentage of your assets in cash and gold. Kate and I don’t own any stocks at all. But there’s a caveat to this. There’s going to come a moment – possibly quite soon – where cash turns from an asset into a liability. When this moment comes, as far as is practical, I’ll be looking to dump our cash.  Stay tuned for more on this in the revised Strategy Report later this month.

QUESTION:

I would love to have some examples of how to short the various markets. I'm a big boy as well as an old man and I'm able and willing to risk about $100,000. 

MY RESPONSE:

There are a variety of choices for shorting the market. There are many inverse ETFs, including single stock inverse ETFs on Tesla [TSLS], Amazon [AMZD] and Apple [AAPD]. Some other inverse ETFs I like are SARK (an inverse ETF of Cathie Wood’s Ark Innovation ETF), PSQ (an inverse ETF of QQQ) and SH (an inverse ETF of the S&P 500.) These all carry expense ratios in the 1% range. 

The other avenue you can pursue is buying put options with expirations twelve months or more into the future. But you have to know what you’re doing – and how to manage risk – before you start buying put options to bet on stock market declines.   

I’m not making any short bets with my own money, because I feel it’s taking unnecessary risk and stress. And we’re not suggesting short selling as a strategy in this newsletter for the same reason. 

QUESTION:

I hold a lot of gold and very little cash. When I want cash I email my bullion merchant/storage/broker, sell gold with the cash landing in my account usually within the hour. Is there any advantage in holding cash when one's gold is so easily converted to cash?

MY RESPONSE:

I like your system. Personally, my gold is not so easily convertible to cash, so I have to keep extra cash around. 

Tom

P.S. I believe the primary trend in the stock market is bearish, but I wonder, what stunt will they pull next to prop it up? With the national debt over 120% of GDP, the Fed in Volcker mode, the world’s best supplier of natural resources outcast from the financial system and the world’s best supplier of manufactured goods struggling with its own economic meltdown, I have to assume the range of options is a lot smaller than it used to be.  

Maybe the day of reckoning is finally here? Maybe they’re finally out of options? Maybe the bear will finally be allowed to complete its job that started 22 years ago? 

P.P.S. My Dad is visiting us from New York. His cancer treatments are over and he’s spending three weeks with us. Here we are watching Dusty (14) play in a cricket match on Sunday…