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Grandpa's Favorite Investment In Trouble

|Includes: iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

Summary

Weak growth everywhere, especially U.S.

Foreign investors are flooding U.S. markets placing faith here but overvaluing the market.

The Fed is at a crossroads, and does not know what do to.

Debt financing and M&A is the go-to strategy for companies.

Bonds have many troubling signs, too much to cover in a bullet point.

*I would like to note this was not accepted as an article, due to the editors feeling it is too "gloomy". Not pushing rhetoric here. Please read and judge for yourself.*

This is a very strange time for investors. Not only are interest rates at a 5,000 year low, but we have economic data that does not support the current "bull market". Stocks are incredibly overvalued and U.S. markets are flooded with foreign investors due to their own domestic weakness. I will cover most of these topics in this article and bring it all together to talk about grandpa's favorite investment, bonds.

Foreign Investors

Foreign owned debt, due to the attractiveness of U.S. markets, has been on the rise in the current bond market. This can be attributed to negative rates and weakening global growth. And, as many have expected, there is faltering growth within China which has caused their 10 year bond yield to fall to it's lowest since 2006. China has also posted the lowest GDP since 1990, and most likely it is even slower than reported. Last month, Germany had sold a 10-year debt at a negative yield, and which means investors are PAYING Germany to borrow. While foreign investors also fear slow growth in their said country, the buy side in U.S. markets has increased, essentially forcing the U.S. to issue new debt in an overpriced market. Countries in Europe such as Italy and Spain are ticking time bombs with horrible credit and hopefully, investors are bracing for impact. This has also lead to foreign investors placing their faith in the U.S. dollar.

The Fed

Confidence in the Fed is withering away and investors are starting to question the competency of Janet Yellen. We should have expected this from Yellen, considering she failed to raise rates when the time was right. Now current data is weak and our economy is not recovering fast enough. The Fed only cares about keeping borrowing costs low for companies and individuals to encourage economic "growth" but it looks like they are out of ideas.

Screen Shot 2016-08-16 at 7.29.53 PM.png

This is clearly an artificial push that is preventing the inevitable from happening, and with the Fed owning so much U.S. debt what happens to the Fed in another crisis?

The ISM Purchasing Managers Index is a great forecasting tool that has more often than not, been successful at predicting a coming recession. Considering that it has already crossed below 50 twice this year, the chances are high.

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Large-Cap Debt Strategies

There are multiple warning signs that are correlated to bonds, but I think it's best we start with the big players in the market first. It seems that large cap companies have had decent earnings this past quarter but once again, mid-cap stocks are failing to produce any earnings that are appealing to a growth investor. Now I find this troublesome since large-cap companies have benefitted from increased regulation in the U.S. thus allowing them to buyout smaller competition, which creates the sense of "real" growth. Then after about a year or so, these large-cap companies decide as the parent company, to use their acquisitions to write off any losses and use these smaller companies old equipment as a tax shield. Many companies are performing these acquisitions only to appeal to shareholders hopes of sustained growth rather than adding value. Am I saying there is no strategy to these buyouts? No, but larger companies would benefit greater from waiting it out until the smaller companies are fairly priced to acquire them. What we're seeing is large quality companies acquiring smaller companies with high EBITDA and little growth potential for investors. On the flip side, there are companies such as Thermo Fisher, which have an already high P/E (31) acquiring FEI Company that has an even higher P/E at (41) and is trading at 4x its price to book. Of course in this example one can argue the acquisition occurred for the potential growth prospects. Yet, we continue to see many large cap companies stray from their core markets trading organic (internal) growth for artificial (external) growth. Although this is common practice in the medical industry, it seems that it is too aggressive in our current market conditions (plus I had to follow this company for a class so bear with me). This thought is further supported by the idea that we have weak growth in a market set correct at any minute. Then comes stock buybacks, which not only raises ROE (which looks great on paper) but creates a false sense of confidence to an investor. After buyback of stock, these overvalued companies begin to issue new debt instruments in order to change their capital structure. History tells us that new issues are good for the seller, bad for the buyer and usually occurs around the peak of the stock market. To wrap this up, we have hit an all-time high of M&A's which signals weak growth, reduced competition and low demand. Now that we covered some of the issues within the companies themselves, we can move on to bonds.

Bonds Show Many Troublesome Signs

Please, take a look at this chart and let that sink in for a little.

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With interest rates at an all time low, debt financing is very appealing for companies since we are expecting rates to rise at some point (December most likely). Which means many companies are rushing to get in on these great debt financing deals. Investors are flocking to pick up junk bonds since investment grade bonds aren't appealing in a market with low rates and low yields. This is troublesome considering more companies have defaulted this year in comparison to last year, thus hitting the highest default rates since '09. Could the bond market really be that fragile? Well, it's possible. All we need are more companies to default and eventually it could become a catalyst for multiple companies to go under. Retail investors in the secondary bond market have a small presence but have been on the rise, which is worrisome due to the transparency of bonds as an investment vehicle. While large institutional investors better understand the risk associated, investment grade yields are still below 4% which historically means junk bonds should not be a choice of investment. With no rise in interest rates, the outstanding debt by these corporations should be showing that junk bonds are not an optimal investment vehicle. The average bid for S&P U.S. HY Corporate Bonds is at 98.67, meaning these bonds aren't offered at a deep discount. Why buy near par, when you can get it around say, 70, with a weak market set to come? It is also possible that if interest rates do rise, investors will run for the exit driving prices down further.

Junk bonds have been overbought in the market especially through the ETF instrument, thus exposing retail and inexperienced investors to this risk. Many investors do not understand this instrument, and don't realize that over the long term ETF's value deteriorate. Most ETFs are institutionally owned, creating high liquidity and high volatility which can cause large price swings in dire times. Below, we see HYG which for those who do not know, is a high yield corporate ETF that many investors are in love with.

(click to enlarge)

The trend of this ETF doesn't look great which is not only overbought, but is deteriorating over the long term.

Speaking to an investment manager at Drexel's Endowment Fund, there are no qualms about the high yield market. We know that bonds are overbought and have been since 2013. High-yielding investment vehicles are used as a hedge against inflation, but why in a time of no inflation, bonds across the board are so overbought? This isn't a trend that has been happening recently, this has been happening for a few years now, and this holds true that many investors are using high yield bonds as a hedge against stagnant wages rather than high inflation. Coupled with low productivity and very weak growth in the U.S., bonds are the go-to for many investors. Either way, more and more investors are looking for income which they are only receiving through high-yield bonds or large-cap stocks paying out a fat dividend.

Government bonds by each state

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The trend here shows government bond defaults are on the rise and it has broken through its 2014 resistance levels, could it go higher? It sure looks like it.

The Next Step

So how can an investor prepare for an event like this? Well for one, buy gold which I had said for over a year now before its rally. Short large-cap companies, short the market, short wherever you see unexplainable growth. And finally, search for deep value even if that means looking outside U.S. markets, such as Japan. Japan is an attractive alternative compared to the overpriced U.S. market and it still is the second largest equity market. I also like the numbers in Japan considering their market's microcaps have good audits from companies such as Deloitte, KPMG, PwC, and Ernst & Young. Japan has a more developed market than others, and has better governance than let's say, China. The USD to JPY for 30 years has shown stability so I'm not too worried and think it will hold purchasing power parity. But most importantly, Japan is dirt cheap. Price to book at some of the lowest levels, profitability is greatly up and most profits are passed thru to employees rather than shareholders. This further supports their efficient culture by keeping people employed, while hiring new employees. The Nikkei is also about the same level as it was 20 years, which better illustrates its cheapness when you compare overall earnings which means the price is stagnant but earnings are up. Also about 1/3 of Japanese equity base is in cash. I think there are some very cheap, profitable companies that could pay off through a deep value strategy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.