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Stop Fracking Around

29500719_sI don’t know anyone who likes volatility in the markets. Currently, people are worried about the recent free-fall in oil prices and the plunge in bond yields to below zero percent in the Eurozone and Japan. Last week, Swiss authorities allowed the Swiss franc to float freely to the Euro. This surprise move caused the franc to soar by 10 percent in one day. Conversely, the Swiss stock market declined by nearly 10 percent, also in one day.
 
Here’s the kicker though . . . none of it was all that unexpected.
 
If you are a student of market history like I am, you know that about every five to six years our economy enters a recessionary period and we have a market correction. And while I cannot predict the future of the markets, one thing I am fairly certain of is that we are an economy of bubbles.
 
Who remembers the Tech Rec of 2000-2003? That bubble burst after outrageous market overvaluation of worthless web companies. The S&P 500 lost about 44 percent over the course of those three years. We all remember the Last Great Recession from 2007 to 2009, which was spurred by the subprime mortgage market collapse. Many financial experts refer to the years from 2000 to 2010 as the lost decade. In fact, by my calculations, if you had invested $100,000 in an S&P 500 index fund at the beginning of the year 2000, and kept it invested in such a fund, then by the end of 2010, your investment would have been worth only about $103,000. You may think that’s not so bad, because you would not have “lost” anything, but if inflation is factored into the yearly returns over that decade, at 3.5 percent, you would have actually lost your purchasing power by about 43 percent.
 
Oh my, those nasty bubbles.
 
A few weeks back I wrote a column titled, “Will You Hear the Screams” (http://old.cutterfinancialgroup.com/will-you-hear-the-screams) in which I talked about another bubble, one inflated by high-yield bonds, and the possible effects of falling oil prices on fracking in the United States. You see, I’ve been focusing on the problems with fracking and the high-yield debt bubble because I believe falling oil prices could become the trigger that causes the high-yield debt bubble to burst, just like the subprime mortgage market collapse was the trigger that caused the housing bubble to burst which, as we all know, led to the last global financial crisis in 2008/2009. (Bubbles just grow bigger and bigger until they either get so overinflated that they burst on their own or something causes them to burst.)
 
What I know is this. Falling commodity prices, specifically oil, are killing countries like Venezuela, Russia, Iran and Iraq. The broader commodity price decline already has affected and will continue to affect almost all emerging countries. Furthermore, falling oil prices will cause frackers in the United States to default on high-yield (or junk bond) debt. Following that will be a default on bank loans and debt issued to companies overseas.
 
Just as falling home prices (which no one expected) triggered the subprime mortgage collapse, falling oil prices could trigger the collapse of the high-yield debt market. Heck, the high-yield bond market already sank 10 percent. And of course, uneducated investors are just focusing on the nightly news telling them all is good with the raging stock markets . . . but the nightly news is largely ignoring this crystal-clear threat just as they, and Bernanke, ignored the subprime crisis when it was looming.
 
In my opinion, the Fed’s Quantitative Easing helped to create the high-yield debt bubble by creating unnaturally low interest rates. Those historically low interest rates coincided with the emergence of fracking in the United States and, as a result, the fracking industry issued considerable amounts of high-yield debt. Now fracking is nearly 75 percent of oil production in the United States and is concentrated in two states, Texas and North Dakota. With oil prices plunging again, the fracking industry, quite simply, cannot be competitive. In order for the fracking industry to price competitively, oil prices need to get back to $80 to $100 a barrel plus, which is unlikely anytime soon.
 
Even Goldman Sachs has reduced its long-term estimates from $90 down to $70 per barrel. With prices so low and continuing to hover around $40 a barrel, many drillers will simply not be able to pay back these high-yield bonds. Remember when we thought it was a good idea for subprime mortgage borrowers to get loans with no down payments? They couldn’t pay their mortgages when home prices collapsed. This collapse in oil prices will likely kill the frackers.
 
Unfortunately, a lot of the media is focusing their commentary on Fed policy and the possibility of rising interest rates. Nope, not me; my eye is on oil prices! Some believe the Fed will not raise interest rates because in three to six months, the economy will not be as strong as it is currently. Either way, the frackers will be out of business and the falling oil prices will therefore trigger the collapse of the high-yield debt market, which could lead to a stock market correction.
 
Now is a good time to have a “gut” check and to follow up with your advisor to review your investment strategy. What happened to your strategy the last time you got caught “frackin’” around, what will change this time? Seek investment strategies that can go risk off, to cash, in troubled times. Unfortunately, many investors may fall victim to a bursting bubble, but not Cutter Family Finance readers, not you, not this time.
 
Be vigilant and stay alert, because you deserve more.