Bear Market Signal #6

Bear Market Signal #6:

Will You Survive the Coming "Great Liquidity Crisis" and Social Upheaval?

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For the past several days, we've talked about credit markets... which might seem strange.

After all, most people own far more equities — whether via individual positions in companies like Apple (AAPL) or Coca-Cola (KO) or the many increasingly popular "passive" funds from firms like Vanguard or Fidelity that simply track the S&P 500 or another index — than bonds or other debt.

A serious crisis typically begins with good or reasonable intentions — for example, the view that buying a home is the American dream. Then, this intent is amplified with leverages. And finally, everyone piles in. That makes it "contagious"...

Housing is a perfect example. In the early 2000s, investors noticed that U.S. housing prices hadn't fallen in living memory. They took that to mean housing prices would never fall. That helped create a massive subprime mortgage bubble, ending with the S&P 500 down more than 50% from its October 2007 highs by March 2009.

Or take "portfolio insurance" sold in the 1980s. This was another reasonable idea — essentially, automatic programs that were designed to protect an investor's portfolio from a falling market. The math behind this portfolio insurance strategy was developed in 1979... and from there, it became more and more popular, especially with large investors like pension funds and mutual funds.

The problem, of course, is when these massive investors try to enact their "protection" plans all at once... billions and billions of stocks will be dumped on the market.

Stansberry Research founder Porter Stansberry — who you'll hear from next Wednesday at our Bear Market Survival Event — explained the "trigger" this way in the Stansberry Digest:

On Thursday, October 15, 1987, Iran hit a super tanker in the Persian Gulf with a Silkworm missile. The ship was U.S.-flagged and carrying crude oil bound for the U.S. market. On Friday, October 16, it happened again. Iran attacked another super tanker.

The market responded badly. Selling led to more selling... and then even more selling. The dynamic hedging programs were driving more and more money out of the market as it fell. The market fell more than 300 points by the end of that week, down about 12%.

The sell orders piled up over the following weekend as the London Stock Exchange didn't open because of a freak storm. A hurricane hit southern England and northern France. More and more investors began to panic. When trading opened in New York on Monday, October 19, it seemed as though the entire world wanted to sell stocks at virtually any price. The market crashed an incredible 22% in one day.

Could that sort of contagion... and sudden crash... happen again today?

Absolutely. And once again, the initial rationale seems reasonable.

Passive investing — buying an index fund rather than individual positions in specific companies — is popular with investors who don't want to worry about beating the market. Instead, they simply "own" the market.

Bloomberg notes that 50% of all U.S. assets under management will be passively invested sometime this year. And Extreme Value editor Dan Ferris says that the tipping point is growing near:

Experienced investors automatically ask, "So what's next?" They know that in financial markets, success tends to sow the seeds of its own destruction...

First, passive funds buy baskets of stocks as new money comes in, without any reference to the fundamentals of the businesses they're buying. When money comes into the fund, they buy. When it goes out, they sell. No due diligence required.

The second problem is that many active managers are penalized for taking contrary positions against the passive buyers. This is because over time, they command fewer and fewer assets relative to the passive herd. So their influence on the marketplace shrinks as the mindless passive herd of buyers grows... and experiences less and less pushback from more rational actors in the marketplace.

Passive investing has the potential to go horribly wrong, precisely because it's so widespread and assumed to be so safe and conservative. Dan continues...

One strength of indexing is that you can easily hold a diversified portfolio in a single fund. But how diversified are you if everybody else owns the same thing you own?

Indexing is a strategy solely based on buying. Selling is not part of the deal. When selling goes into overdrive, indexers will feel less like they're making a safe, conservative bet and more like they're juggling flaming chainsaws.

Of course, we can't know exactly what will happen if indexers start selling. Maybe enough of them will hold on for the long term that we'll have nothing to worry about.

What I do know is this: What the wise do in the beginning, fools do in the end.

Global banking giant JPMorgan even recently warned that the next market crash could create the biggest social conflict in 50 years. Its global head of macro quantitative and derivatives strategy, Marko Kolanovic, recently laid out how the "Great Liquidity Crisis" could happen.

He says the shift from active investing to passive strategy will handcuff markets in a crisis — and force them to automatically sell into a market drop, making a sell-off worse. And he believes that while this liquidity crisis will startin the markets, it will ultimately spark a "real world" social conflict not unlike what America experienced during the 1968 Vietnam War.

If you can remember the anger and resentment of the late 1960s, you know that this combination of economic and social upheaval is devastating. As Porter recently wrote:

All over the country, there was one clash after another...

Small farmers fought banks and railroads. Union workers battled their bosses and federal judges. On college campuses, students fought anyone with authority. Election rallies routinely ended in violence.

Things were so bad, Lyndon Johnson decided not to run for re-election. Martin Luther King Jr. and Robert Kennedy were assassinated.

In 1968 alone, there were violent uprisings in more than 120 U.S. cities.

Billionaire investor Ray Dalio went a step further, comparing today to the 1930s. "The American dream is lost," he said recently on 60 Minutes.

If you look at history, if you have a group of people who have very different economic conditions and you have an economic downturn, you have conflict.

In the 1930s, for example, you had four major countries that were democracies, that chose not to be democracies because they wanted leadership to bring order to the conflict. I'm not saying we're going to go there. I'm saying that right now, it's a huge issue. It's unfair, it's unproductive, and it threatens to split us.

Dalio says that to reform America, "We can do it together, or we will do it in conflict... a conflict between the rich and the poor." He predicts a 60%-65% chance that the nation goes down the path of conflict.

We write this not to scare you. But when major banks and billionaires are all watching for social upheaval in the years to come — all sparked by a financial crisis — you should know how to use the same strategies to protect your portfolio that they're using.

Porter Stansberry and legendary investor Jim Rogers will discuss why the market is particularly vulnerable to political rhetoric and social unrest right now... how we could see a kind of panic in America that we last saw during the Great Depression... and why we might not even make it to the 2020 presidential election before all this begins. Make sure you listen in next Wednesday at 8 p.m. Eastern time.

And for our 7th Bear Market Signal, we'll talk more about leverage... and why the sorts of products that Warren Buffett infamously called "financial weapons of mass destruction" might already be in your retirement account. Click the "Bear Market Signal #7" button below to learn more.

Special Guests

Jim Rogers

Jim Rogers

Jim Rogers is an American businessman, investor, traveler, financial commentator and author based in Singapore. Rogers is the Chairman of Rogers Holdings and Beeland Interests, Inc. He was the co-founder of the Quantum Fund and creator of the Rogers International Commodities Index.

Porter Stansberry

Porter Stansberry

Porter Stansberry founded Stansberry Research in 1999 with the firm's flagship publication, Stansberry's Investment Advisory. He is also the host of Stansberry Investor Hour, a weekly broadcast that has quickly become one of the most popular online financial radio shows. At Stansberry Research, Porter oversees more than twenty of the best editors and analysts in the business, who do an exhaustive amount of real-world, independent research.

Austin Root

Austin Root

Austin Root is editor and portfolio manager for the Stansberry Portfolio Solutions products and American Moonshots. He is also director of corporate development at Stansberry Research and a senior analyst for Stansberry's Investment Advisory.