As the world celebrates Christmas, stock markets are cratering around the world, with the US leading the way. Since October, when the Dow Jones Industrial Average (DJIA) peaked at 26,951.81, it’s lost nearly 4,000 points, down 15.1%. The S&P 500 has lost even more: 15.8%.
The red ink in share prices has erased trillions of dollars from global balance sheets. The stocks comprising the S&P 500 have lost $2.39 trillion in December alone.
When asked why stock prices are falling, the talking heads on television and the internet point to the Fed’s continuing interest rate hikes and the ongoing trade war with China. Those factors are important, but there’s another component that gets less attention: soaring levels of debt. Much of that debt is of highly dubious quality.
Earlier this month, the International Monetary Fund reported that the total world debt load is an incredible $184 trillion. That’s 225% of the entire world’s GDP and nearly double what it was in 2007 at the eve of the last financial crisis.
You may recall that the 2007 to 2008 financial crisis was set off by excessive debt. What started the ball rolling were a series of interest rate increases by the Fed. Homeowners with adjustable mortgages in which payments were tied to interest rates started to default in droves.
Many of the mortgages that ended up in default were “subprime;” extended to borrowers with poor credit ratings or who weren’t asked for proof of creditworthiness. In many cases, the mortgages were for 95% or more of the value of the home being financed. Meanwhile, the financial wizards on Wall Street turned sub-prime mortgages into mortgaged-back securities called collateralized debt obligations that were greedily lapped up by individual investors, hedge funds, and even pension funds.
Would you lend 95% or more of the value of a home to someone with bad credit? I wouldn’t, and no less an authority than Warren Buffett warned in 2003 that mortgage-backed securities and other derivatives (i.e., contracts whose values are derived from the performance of an underlying asset) were “financial weapons of mass destruction.”
However, with the help of global credit rating agencies, the purveyors of mortgage-backed securities were able to do something roughly akin to converting lead into gold. Credit rating agencies reasoned that owning a collection of sub-prime mortgages was much safer than owning just one. After all, it was unlikely that all the mortgages would default simultaneously. On this theory, instead of rating the collection of sub-prime mortgages as junk bonds, they gave them the highest possible ratings.
We all know what happened next. Millions of borrowers defaulted on their mortgages, and the value of collateralized debt obligations collapsed. Then the banks and insurance companies backing those securities started to collapse, along with stock markets worldwide.
Now it’s happening again. Credit rating agencies are once again using questionable assumptions to give trillions of dollars in dodgy debt much higher ratings than is deserved. Ratings agencies assign credit ratings based on a sliding scale ranging from AAA to D (Standard & Poor’s) or Aaa to D (Moody’s). The lowest rating for supposedly “investment-grade” debt is BBB- or Baa3.
Since 2007, corporations worldwide, like homebuyers a decade ago, have been borrowing money at a dizzying pace, fueled by the zero interest rate policy in effect at the world’s central banks. And the volume of debt rated BBB- has ballooned from $700 billion in 2008 to $3 trillion today.
Drilling down into these numbers, there are some alarming statistics. In 2007, companies rated BBB- had an average net debt of 2.1 times earnings. Today, that ratio is 3.2. And more than a third of companies with a BBB- rating have a debt-to-earnings ratio larger than five.
I won’t be surprised if a large chunk of supposedly investment-grade debt is effectively junk and written off if the correction we’re now experiencing in the stock market turns into a recession. And that could trigger a financial crisis that dwarfs the one that we experienced a decade ago.
Simply put, it’s time to get defensive. I’ve already liquidated virtually every stock in my portfolio and currently hold most of my assets in gold and US Treasuries. Yes, the Treasury will default on its debt obligations someday, but probably not in the next few months. And since stock prices started falling in early October, the price of gold has risen 6.4%, even in the face of rising interest rates. That’s almost unprecedented in times when inflation fears are subdued, as they are now.
I’ve also sharply reduced the amount of money I keep on bank balance sheets and taken other precautions I recently shared with our Inner Circle Gold members. To try a no-risk subscription to learn more about ways to protect yourself from the next financial crisis, click here.
