Serious WARNING For The USA Stock Market

Nobody likes to read bad news. But there are serious problems in the underlying fundamentals of our equity and credit markets. Rising interest rates are going to expose these problems, accelerating the inevitable end to the current credit cycle and this bull market in stocks.

I am more and more convinced that the next several years will be extremely difficult for most equity and bond investors.

I'm very worried that you are overexposed to these risks.

Please. Please. Please. Read this blog carefully.

I don't care whether you agree with me. What matters to me is that you get a complete and detailed warning about the serious risks that exist just below the surface in our equity markets. How much risk you continue to take is, of course, up to you. But unless you understand these risks, you can't make informed decisions. And I doubt anyone else will be able to give you the information I detailed below.

(By the way, you have my permission to share this week's Digest with anyone you think should be aware of these problems. I hope some of your friends will choose to read. But even if no one does, I still believe this information should be widely known among all investors.)

What's the big problem?

The extremely low interest rate regime of the last decade (created by the Federal Reserve manipulating the credit markets) encouraged many companies that should have failed, to continue to borrow money. As a result, there are now several hundred publicly traded corporations that cannot possibly repay their debts. These "zombie companies" cannot even afford their artificially low interest rates.

Several hundred American companies are destined for bankruptcy or are on the verge of it. The stock market hasn't factored in these problems, at all.

Nobody has paid much attention to these zombie companies yet, not even when major companies like toy retailer Toys "R" Us, suddenly liquidated. (When is the last time you can remember a major U.S.-brand being liquated? Not just bankrupt, but every last item being sold off at an auction?)

The market is going to focus more and more of these zombie companies for one simple reason: Interest rates are, for the first time in almost a decade, rapidly increasing. The interest rate on the 10-year U.S. Treasury note has been going up for almost a year and recently broke past 3%. This is a key level, and it implies grave danger lies ahead for highly indebted firms. Many companies cannot refinance their debts at these levels.

I've included a list of the biggest zombie companies below.

So if you do nothing else, read below. Learn what indicators will appear as the credit cycle rolls over. Know what stocks to avoid at all costs. I'll show you 10 of them in this week's Digest.

Our equity and credit markets suffer from serious, fundamental problems. These problems are big enough that I'm growing increasingly concerned that future investment returns, in both stocks and bonds, will be extremely poor.

The heart of the problem is, far too many American corporations have borrowed more money than they can possibly afford to repay.

Here's an example of what I'm talking about...
General Electric (GE) was, at one time (the early 2000s) the most valuable corporation in the world. It manufactured everything from light bulbs to jet engines. It was essentially a corporate version of America itself. The financial excesses of the past 30 years crippled this business. Its managers engaged in every kind of accounting and financial hijinks you can imagine. They left this iconic American company saddled with more than $60 billion in net long-term debt. (Please note: That's net debt – after subtracting all of GE's cash.) Even with record-low interest rates, GE still faces interest obligations of almost $3 billion per year.

And here's the problem: These interest rates are likely to rise a lot faster than GE's ability to grow earnings. Currently, GE earns only $3.6 billion year, when measured by "EBIT" – that's earnings before interest and taxes. If its interest expenses grow and its earnings don't keep up, GE will have a difficult time paying its debts in its current structure.

And don't forget, GE requires at least $7 billion a year in capital investments (capex) to maintain its facilities and position its businesses for future growth. In other words, while GE can do some things to avoid bankruptcy (like cutting its annual capex spending), it isn't earning enough capital to finance both its debts and future growth. It is caught in a death spiral.

GE's problems are now well known to investors because last year the company's new CEO came forward and told everyone what had really been going on in the company. (We'd been reporting on GE's weak financial position for years.) You can see what happened to the company's stock price as these balance sheet issues became clear to the market.

Yes, GE is only one company...
And it's not as important as it used to be. But the business still has a $125 billion market cap. It employs nearly 300,000 people. GE's troubles are going to matter, to both the markets and our economy. And unfortunately, GE isn't the only big problem that's lurking. Let me show you what I mean.

Jim Grant, publisher of Grant's Interest Rate Observer, recently published some research done by Bianco Research on the overall level of debt in the U.S. equity market. Bianco wanted to know how many more GEs (giant companies hugely encumbered by debt) were out there. So it asked a simple question. Based on the three-year average of cash earnings (defined by EBIT), how many U.S. firms can't afford their debt service? Bianco found 14.6% of the S&P Composite 1500 (the 1,500 largest public companies in the U.S.) couldn't afford the interest on their outstanding debts. That is, the three-year average cash earnings (EBIT) wasn't big enough to cover their interest expense.

I don't believe one in 100 American investors understands how big of a role new debt has played in the equity boom that we've seen over the last several years. Today, corporate debt in America is a new all-time high. American companies have never held so much debt relative to the size of our economy ever before.

*** What do you think is going to happen if interest rates keep rising (which seems likely) or a recession hits?

Sooner or later, in one way or another, these problems will become clear to more and more investors – just like GE's problems came to light over the last year. There will be catastrophic losses, unlike anything you've ever seen before. How?

At the peak of the last big equity market bubble (2007), only 5.7% of America's companies were in the same dire straits. That is, back in 2007, only 5.7% of America's top 1,500 companies weren't earning enough to cover their interest payments. The resulting bear market saw stock prices fall by 50% and led to a national bailout of the banking system. What will happen this time, when almost three times as many companies are in this critical financial position?

Here's the part to remember...
Analysts have put together a list of the 10 worst examples of big companies with horrible underlying fundamentals.

The list is below. Note, GE is in the best position. GE is still earning enough to afford its interest, but only just barely. The other companies on this list don't make enough money to afford their current interest payments. Some of them wouldn't make enough to afford their interest payments even if their earnings doubled (Sprint, SeaWorld Entertainment, Endurance International).

Keep in mind, these firms are only a small sample of the full problem in terms of the number of companies...
More than 100 major companies are in this poor financial condition. But my sample list isn't small in terms of capital. These companies, collectively, represent almost $200 billion in market value. They hold $126 billion in debt, which costs $6.9 billion a year to service. That's a 5.5% annual interest rate, collectively, for companies that aren't creditworthy in any rational sense of the word.

With 10-year U.S. Treasury notes now paying 3% annually, who in the world is going to continue to finance these debts at less than 6% annually? No one. What about 8% annually? Doubt it. What about 10% annually? Maybe. But explain how these companies can afford higher interest rates (almost double what they're paying now) when they can't make ends meet at 5%? It won't happen.

What will happen?
I don't know. But what I do know is that investors in these stocks, and in a whole bunch more like them, are destined for severe disappointment. And that doesn't bode well for investor sentiment, the market multiple, or the general level of the stock market.

What's the most dangerous thing in the world to an aging bull market, made up of firms with a record-high level of debt? Rising interest rates. What do we see in the market today? Rising interest rates.

Time is running out...

I don't know how many people will actually learn anything or how many people will take these warnings seriously. What I do know is, virtually every time investors get excited, a lot of people lose money. That's what happened in the Internet stock bubble of 2000. That's what happened in the real estate/commodity bubble of 2008. And that's what happened – in a truly astounding way – during the bitcoin bubble last fall.

I know, this cycle is going to repeat. I just don't know exactly when. Please listen to me. Time is running out on this bull market. You don't need to sell everything, but lower your exposure to the equity markets to less than 60% of your portfolio. Put some of your capital some place safe. Buy some gold. Buy very safe bonds. Buy some local real estate that you know well and can always rent. Get out of debt. Follow your trailing stops. Raise cash when you stop out. Realize that over the next 12-36 months, the investors who win will be the ones who survive. You can choose to be one of them. You really can. But you need to act now.

I mentioned a few triggers to watch for...
The most important indicators and warnings will come from the corporate-bond market. The three most important indicators are:

The prices of junk bonds. As credit tightens, the prices of junk bonds will fall. You can watch junk-bond funds – like the Shares iBoxx $ High Yield Corporate Bond Fund (HYG) – to monitor these prices.
The interest rate "spread" between high yield debt and U.S. Treasury securities. As defaults grow, the increased risk will be expressed in much higher interest rates for weak borrowers.
The 10-year U.S. Treasury yield. If safe yields on government bonds reach 4% or more, there will be complete carnage in the corporate-bond market, where average rates to refinance outstanding debts will probably double.
And just so you know, default rates right now are near all-time lows. Nobody is afraid – yet.

I'll do my best to keep you up to date as the default rate grows. For now, I'm looking for more situations like Toys "R" Us, where radically overleveraged, private-equity managed businesses fail because they're simply denied any additional credit. That's what's going to happen... more and more often... until one of these deals blows up and triggers a general panic.

If I could tell you exactly when, I would. But there's no doubt it's coming.

Beat the rush. Prepare now.