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Business/Finance See other Business/Finance Articles Title: The Subtle Lunacy of Raised Expectations The Subtle Lunacy of Raised Expectations By Michael E. Lewitt, Global Credit Strategist, Money Morning • April 17, 2016 I cannot remember another time when the gap between reality and the things that are written to describe it was as wide as it is today. While this is always the case in the political realm, where the government lies to its citizens, it also pertains to the investment landscape. While a minority of strategists keep warning that the epic build-up of global debt is going to lead to crisis, the mainstream media and Wall Street continue to chirp about "the return of the consumer" and "sustainable economic growth." But saying so doesn't make it so and the world is running headlong towards another crisis. Last week, we saw three significant corporate bankruptcies that are only the beginning of what is going to be a record default cycle. Peabody Coal (OTCMKTS: BTU), Energy XXI Ltd. (Nasdaq: EXXI) and Goodrich Petroleum (OTCMKTS: GPDM) finally threw in the towel. And other large energy producers like Sandridge (OTCMKTS: SDOC), Linn Energy (Nasdaq: LINE), and SunEdison (NYSE: SUNE) are likely to follow in the near future. The Danger in the Junk Bond Market is Growing According to the law firm HaynesBoone, 60 North American oil and gas companies with $20 billion of debt have gone bankrupt since energy prices crashed in 2014. So far in 2016, 46 companies have defaulted, the highest number of year-to-date failures since the financial crisis in 2009 when there were 67 defaults during the same period. Of these defaults, 37 were in the United States, 7 in emerging markets and one each in Europe and other developed nations. Last year there were 31 defaults over the same period. But this is just the tip of the iceberg in a junk bond market that has grown to over $4 trillion globally. Martin Fridson, the dean of junk bond analysts, produced a study in October 2014 showing that a normal default cycle (that is, one that does not feature a financial crisis) will produce approximately $1.6 trillion of debt defaults. Mr. Fridson's study assumes normal default and recovery rates over the 2016-19 cycle. There are good reasons to think that defaults and recovery rates may be more severe than normal, however, due to the commodities meltdown and record levels of debt sitting on corporate balance sheets around the world. The only mitigating factor is the low interest rates that facilitated epic levels of borrowing but are now delaying defaults because companies' borrowing costs are so low. Rather than wait for the Fed to normalize rates, however, the market has raised interest rates for many weak borrowers such as retailers and energy companies, making it impossible for them to refinance their debt at reasonable rates when it comes due. This will lead to higher defaults over the next couple of years for companies able to cover (barely) their interest costs but unable to refinance their debts. Corporate America is more leveraged than it was before the financial crisis – much more leveraged in fact. And it is spending more than it is taking in by a wide margin. According to Societe Generale strategist Andrew Lapthorne, companies are spending 35% more than their operating cash flow, the biggest deficit in 20 years of collecting data. Even more disturbing is the fact that the lion's share of this spending (which, to reiterate, is being financed with debt) is being used for unproductive activities that won't produce the income needed to service or repay that debt. Rather than borrow money to expand their businesses, corporations borrowed money to engage in more than $2 trillion of stock buybacks and trillions of M&A transactions at inflated stock prices in a grossly overvalued stock market that is being kept afloat by unprecedented central bank liquidity operations (i.e. zero or negative interest rates and quantitative easing). When the smoke clears – and it should clear any minute – these corporations will be left with too much debt and too little earnings and cash flow to deal with it. The only factor separating overleveraged corporations from serious problems is low interest rates, something about which the Fed is no doubt aware. This is one reason why the Fed is terrified to raise rates (the other reason is that government finances are even worse!). Any serious effort to normalize interest rates will send more junk-rated companies into bankruptcy and damage the earnings of higher-rated companies sitting on huge amounts of debt. Apologists for this sorry regime argue that Corporate America is sitting on huge amounts of cash. That is true but it doesn't tell the real story. First, much of this cash is trapped offshore and cannot be domesticated without large tax hits due to the idiocy of the American tax code. Second (and more important), Corporate America's cash holdings are concentrated among a small number of companies led by large banks (JP Morgan, Citibank, Bank of America, Wells Fargo), Apple, Inc. (Nasdaq: AAPL), Microsoft Corporation (Nasdaq: MSFT) and other behemoths. Most corporations, particularly those with junk ratings, do not have large cash reserves and are sitting on weak balance sheets that they are finding increasingly difficult to maintain. Investors Need to Take a Step Back Investors, however, are oblivious to such realities. Last week, they again poured money into the riskiest emerging market and junk bond funds. Emerging market debt funds attracted $1.6 billion, their eighth week of inflows, while junk bond funds sucked in another $700 million from eager beaver investors. They are being seduced by the recent sell-off in the U.S. dollar (which helps emerging markets) and a strong recovery in the junk bond market after a terrible start to 2016, ignoring the longer-term risks of chasing returns and economic reality. If you are one of those who believe that the junk bond market is going to produce attractive risk-adjusted returns over the next several years, I implore you to look at the facts and exit this market before you lose a lot of money. You should avoid junk bond ETFs such as (NYSE: HYG) and (NYSE: JNK) as well as junk bond mutual funds and similar vehicles. The stock market continues to drag investors close to the cliff. Last week, the Dow Jones Industrial Average rose 321 points, or 1.8%, while the S&P 500 jumped by 33 point, or 1.6%, to 2080.73. The Nasdaq joined in the party by rising 1.8% to 4938.22. To illustrate the insane exuberance infecting some stocks, over the last 10 months just two companies, Facebook, Inc. (Nasdaq: FB) and Alphabet, Inc. (Nasdaq: GOOG), added nearly one-quarter of a trillion dollars ($250 billion) in market cap. This is a bubble. First quarter earnings season, which began last week, is going to be lousy. Over $7 trillion of debt around the world is paying negative interest rates, damaging the earnings of banks and insurance companies. Stock investors are counting on the Fed to keep interest rates low forever, ignoring the fact that low interest rates are a sign of economic weakness rather than strength. The Fed may indeed persist in error, but investors should not follow them. They should reduce equity exposure, avoid junk bonds, buy gold and save themselves. moneymorning.com/tag/gold-prices/ Poster Comment: Stay out of equities and buy precious metals and survival food, including water supplies. 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