Stocks kept rallying last week despite the fact that economic conditions are not improving anywhere in the world.
Investors predictably celebrated the European Central Bank's (ECB) decision to lower interest rates further below zero and to buy more debt (including investment grade corporate bonds) in a continuation of its desperate efforts to revive a moribund European economy.
The fact that investors are willing to celebrate government actions to confiscate their savings through negative interest rates illustrates the short-term mentality driving markets closer to a day of reckoning.
You just cannot grow economies by destroying capital, yet that is precisely what negative interest rates accomplish.
That's bad, but it's not the immediate concern right now…
We Could See a Wave of Energy Defaults Soon
Oil prices also rose sharply last week but experts remain divided over whether they will keep rising. For example, Goldman Sachs warned that the rally will run out of steam.
One reason oil rallied was because the U.S. dollar weakened. The correlation between oil and the dollar is very strong. Even if prices settle in the $40s, it will be too late for many leveraged energy companies.
Bloomberg reported on Friday that investors are facing $19 billion in energy defaults in the near future.
This wave of defaults could start within days as Energy XXI Ltd. (Nasdaq: EXXI) ($2.875 billion of debt), SandRidge Energy Inc. (OTCMKTS: SDOC) ($4.131 billion), and Goodrich Petroleum Corp. (OTCMKTS: GDPM) ($455 million) are in final negotiations with lenders.
These are three of at least eight oil and gas producers who have missed interest payments on their debts, the final step before declaring bankruptcy or reaching an out-of-court restructuring agreement with creditors.
The other companies on the brink are: Ultra Petroleum Corp. (NYSE: UPL) ($3.197 billion), Chaparral Energy PLC ($1.798 billion), Pacific Exploration and Production Corp. (TSE: PRE) ($5.428 billion), Venoco, Inc. (NYSE: VQ) ($708 million) and Warren Resources Inc. (Nasdaq: WRES) ($453 million).
Despite this rising tide of defaults, the high-yield bond market rallied in recent weeks as investors poured huge amounts into junk bond ETFs and mutual funds.
The average yield and spread on the Barclays High Yield Bond Index fell to 8.55% and 666 basis points last week, down sharply from over 10% and nearly 900 basis points a few weeks ago.
Readers should not be fooled, however, by this rally and should not join those who are throwing money at this market. The new issue market for high-yield bonds remains very weak while the market for collateralized loan obligations (CLOs), which invest in high yield bank loans, remains closed so far this year.
As Defaults Cascade, the Rally Will Hit a Wall – Hard
The one thing that scares high yield investors more than anything is defaults and the default cycle has been delayed by low interest rates that allow companies to stay out of bankruptcy longer than they should.
U.S. corporations are much more leveraged than they were in 2007 before the financial crisis and weakening earnings suggest that they will have a hard time paying back all of the money they borrowed since the financial crisis.
The Federal Reserve meets next week but is unlikely to raise rates – at least not yet. As both inflation and employment numbers move closer to the Fed's targets, the Fed is running out of excuses to further normalize interest rates.
While I originally did not expect the Fed to add to its December rate hike this year, the strong stock market gives it more breathing room to do so.
This is one reason why the current stock market rally is likely to end soon. Markets sold off sharply after the Fed's December rate hike and will likely do so again the next time the Fed hikes.
A Stronger Dollar Could Wreak Havoc Here
One factor keeping the Fed up at night is fear that further rate hikes coupled with moves in the opposite direction by the ECB and Bank of Japan will push the dollar higher.
The U.S. Dollar Index fell on the week to 96.20, right in the middle of its 52-week range of 92.62 to 100.51.
Like many other financial instruments, currencies are not acting in ways consistent with the textbooks, which is confusing investors and policymakers.
The Bank of Japan's most recent move to weaken interest rates was expected to weaken the yen, but the yen rallied instead. The euro reacted in the same way after the ECB's latest move.
Investors should keep an eye on the dollar in the weeks ahead to gauge what the market is going to do next.
If the dollar starts strengthening again, that would be bad news for oil (which rallied toward $40/barrel last week) and stocks.
All three indices have now cut their 2016 losses. The rally has all the earmarks of a bear market rally – tepid volume, narrow breadth and the weakest and most-shorted stocks rising the most.
Earnings Won't Help, but Gold Will
Stocks have traded back to valuations that may make further moves difficult to achieve, especially with earnings continuing to fade.
The S&P 500 is now trading at roughly 17x consensus 2016 earnings. But when you adjust those earnings to remove all of the non-GAAP adjustments that companies use to disguise what is really going on, the multiple is over 20x.
Like Fox Mulder in The X-Files, investors desperately want to believe that these phony earnings numbers are correct, just like they want to believe that central banks can continue to support markets in a slow-growth, overleveraged world.
Like Mr. Mulder, however, they are likely to be disappointed to learn that the aliens are little more than a government conspiracy to deprive them of their liberty and their money.
Some investors understand this, which is one of the reasons that gold is doing so well this year.
While gold is up about 20% on the year and gold mining stocks are up much more (40-60% in many cases). The largest gold ETF, SPDR Gold Trust (ETF) (NYSE Arca: GLD) has moved from $101.46 to $119.41 this year while Market Vectors Gold Miners ETF (NYSE Arca: GDX) has jumped from $13.72 to $19.98, Global X Gold Explorers ETF (NYSE Arca: GLDX) has jumped from $16.43 to $23.03 and Market Vectors Junior Gold Miners ETF (NYSE Arca: GDXJ) has popped from $19.21 to $27.15.
I recommended GLDX and GDXJ as well as Sprott Physical Gold Trust (NYSE Arca: PHYS) and Central Fund of Canada Limited (USA) (NYSE MKT: CEF) in January and investors should maintain positions in gold.
Gold is a play on monetary instability, something that central bankers are delivering in droves. Gold could hit $1,400/oz. in this rally, but over the long term it will trade at much higher prices than most investors can imagine as central banks complete their mission of destroying the world.
Michael is showing his Sure Money Investor readers even more ways to get the most possible profit from these bear market rallies. He's recommending downside protection, too. Click here to get Sure Money Investor and you'll get his Super Crash report, too.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.