Landon Whaley, editor of The Whaley Report, discusses three "red flags" — leverage, earnings and defaults –that suggest investors need to be prepared for potential downside risks. He also explains the benefits of owning gold in the current uncertain environment.

Steve Halpern:  Joining us today is Landon Whaley, editor of the Whaley Report and one of the smartest guys in the advisory business.  How are you doing today, Landon?

Landon Whaley:  I'm doing well Steven.  Thanks for having me.

Steve Halpern:  Now I'm always fascinated by your newsletter -- which assesses the financial markets from a technical and fundamental basis as well as from a psychology standpoint.  Could you explain how important sentiment and psychology is in your decision-making process?

Landon Whaley:  Yeah, absolutely.  One of my core philosophies is the belief that people are innately flawed decision-makers and that if I can understand this "humanness", it can give me a huge edge in market.  

In the behavioral gravity component of my investment framework, I track multiple factors, which allow me to quantify this humanness component.  Specifically, what I'm trying to track Steven is how investor perception of a given market is changing through time.  

Understanding how this perception changes is critical to successful investing because the best opportunities in my experience come when the public's perception of a market diverges from what the fundamental and quantitative gravities are telling me about the likely direction of that market.

Steve Halpern:  Now, you recently published a report called red flags, which are not necessarily absolute signs but are cautionary warnings.  Could you expand on what you mean by Red Flags?  In light of all we've discussed about psychology as a factor and your approach, could you touch on why it's so difficult for investors to see these signs while they're occurring?

Landon Whaley:  Sure, yeah, well I liken red flags in financial markets to the red flags that you'll see in a relationship.  During the course of a relationship the seemingly little things that make you scratch your head like if she wants to have you meet her family within three weeks of dating.

But, inevitably, we overlook these red flags until one of two things happen. Either the relationship ends and all the red flags become readily apparent or the red flags stack up with such consistency that you have no excuse but to pay attention.  

The same exact thing happens in financial markets.  There are always warning signs in the days and months leading up to a big event; you just have to pay attention.  

The problem is that they're so difficult to see as they're occurring because in my belief, most market participants are either looking backwards at data that's four months old, or they're paying attention to forecasts which are trying to tell you what's going to happen three months into the future.  

I've been trading markets for almost 20 years and I think one of the biggest advantages you can have over other investors is to better understand what is happening right now rather than looking backward or looking forward.  

The perfect example of this is the month leading up the financial crisis.  The S&P set a brand-new all-time high in October 2007.  

In the eight months leading up to that all-time high there were seven distinct red flags that should have sounded alarms.  In February of that year, HSBC announced the first losses due to sub-prime.  

In May, Bernanke acknowledged the fact that there were a growing number of mortgage defaults.  In June, the Bear Stearns hedge fund that invested solely in sub-prime mortgages went belly-up and investors got nothing.  In August, the Fed cut rates by 50 basis points and then less than a month later cut rates again by 50 basis points.  

Finally, in October, again, this is all happening before the S&P peaked, we had the Merrill Lynch CEO resign because of $8 billion in sub-prime loss and we had UBS, which is one of the largest banks in the world, announce a $4 billion loss due to sub-prime.  

We had ample warning before the wheels came off.  Ever since then, I make it a point to keep track of red flags and periodically review them to see what kind of picture's developing.  I'm interested in being in the small minority of investors who aren't taken by surprise when the next calamity hits financial markets.

Steve Halpern:  In the current environment you see several red flags that are causing you to take some concern.  The first is leverage.  Could you explain that?

Landon Whaley:  Sure.  So far this year, Steven, we've had $962 billion of investment-grade debt issued and we're actually on track to set an all-time record.  What this means is that the US corporate bond market has more than doubled since the end of the financial crisis and yet debt is being issued at a faster and faster pace.  

The enhanced demand for US corporates started right after the crisis when retail investors had to reach for yields because of the Fed's policies.  The demand lately has been driven entirely by foreign investors who are trying to escape negative yield elsewhere in the world.  

The problem with these two investor segments driving demand is that they don't normally play in the corporate bond sandbox.  This means that a slight shift in Fed policy or in the policy of other central banks could have both groups running for the doors.  

The other problem of course is that the negative rates are forcing people into US debt have been artificially engineered by central banks.  

What happens when yield starts to rise again?  My back of the envelope calculations suggests that for every 1% rise in US yield approximately $1 trillion of corporate bond value will disappear.  This is going to put a real hurt on primarily pensions and insurance companies because they're the main buyers of debt today.  

On top of all this, US corporations have been propping up the equity market with record amounts of share buybacks and how do you think they've been paying for these buybacks?  With credit.  

For instance, companies in the S&P had a taxable deficit of $150 billion per year because of share buybacks.  This deficit is being entirely funded by the issuance of new debt.  

Now I get why this kind of activity makes sense given the investor demand and a low rate.  The problem is that this level of borrowing just isn't sustainable.  If demand goes away or if yields rise even modestly, corporations are going to be in a world of hurt and this adds up to one huge red flag for me.

Steve Halpern:  Now the second red flag that you've noticed lately is related to earnings.  What do you see in this situation?

Landon Whaley:  Sure, well, you get all these investors rushing into corporate debt driving up leverage.  The problem is it's occurring at a time when earnings are declining and the US dollar is at six-year high.  

As for earnings, the second quarter of this year marks the first time since the financial crisis that corporate earnings have contracted for five straight quarters.  

Not only that, but we're now two and half months into the third quarter and earnings estimates have continued to slide.  If earnings contract for a sixth consecutive quarter, that would be a huge red flag.  

As with greenbacks, the dollar's been in a downtrend since December, but again, remains at six-year highs.  This is an issue because you have companies that become heavily reliant on overseas revenue.  

Obviously, a stronger dollar cuts into those international profits and negatively impacts corporate earnings.  I expect the dollar to remain elevated for the foreseeable future, which means it's going to continue to cause a headwind for US earnings.

Steve Halpern:  Finally, you look at the potential for defaults as another red flag.  Could you expand on that?

Landon Whaley:  Yes.  Specifically, Steven, with defaults the problem with that is investors don't seem to care about it right now.  Year-to-date, the US has had as many defaults as it did all of last year and we're seeing the same monthly pace for defaults as we saw post-crisis back in 2009.  

It's true half of those defaults have occurred in the energy space, but still in my world a default is a default.  We also have the highest number of at-risk corporate bond issuers since 2009.  

There are currently 250 companies with about $360 billion in debt that are considered at-risk.  This number's important because at-risk companies are 10 times more likely to miss a bond payment than other issuers.  

Taken individually it's easy to rationalize or overlook any one of these red flags, but taken together they paint a very vivid picture and that picture is that central banks have pushed yields negative, forcing investors to reach and allow that money to find its way into the corporate bond market.  

The corporations are happy to issue the debt because demand is insatiable and they can borrow money at a rock bottom rate.  The problem is, as I said earlier, none of this is sustainable because the leverage is growing at a record pace while earnings are deteriorating, the US dollar is elevating and causing problems, and default rates are at the highest level since right after the crisis.

Steve Halpern:  Finally, wrapping this together, based on this market assessment, could you highlight some of the ETFs that you're currently recommending so that your subscribers are positioned for any of these red flags that might occur?

Landon Whaley:  Sure.  Well, as you know, I like trades that can win in a range of possible outcomes, not simply one particular outcome.  Right now as we enter the last couple months of the year, being long gold is that trade for me.  

You could use the iShares SPDR Gold ETF (GLD) to replicate this trade. Fundamentally, nothing's going to change dramatically between now and the end of the year.  

The divergence between Fed policy and the policy of just about every other central bank on earth will continue to provide a nice tailwind for gold.  

Quantitatively, there are two things I'm looking at.  First is gold price action has been consolidating for a couple of months and is trading at the lower end of that range.  To me that's a very bullish sign.  

Second is gold's relationship to volatility.  Gold is one of only four markets that I track, which has a positive relationship, meaning that when volatility increases, there's a high probability that it pushes gold price higher.  

We've been in a historically low volatility environment in recent months, but make no mistake, volatility is getting ready to increase significantly. Seasonally, volatility tends to increase anywhere between 30% and 40% during September and October as we come out of the summer months.  

This year, we've got the added bonus of significant central bank meetings as well as a US election involving Donald Trump, all of which should push overall volatility higher.  

Then on the behavioral side, everything looks bullish as well.  Specifically, I like the fact that investor positioning in the gold future's market is not at extreme levels and there's been a whole lot less gold rhetoric on the various media outlets in recent weeks.  

To summarize, being long gold is the only trade I see right now that will work in a wide range of possible scenarios as we close out 2016.

Steve Halpern:  Again, our guest is Landon Whaley, Editor of the Whaley Report.  It's always fascinating hearing your thoughts.  Thank you so much for taking the time today.

Landon Whaley:  Steven, thank you again for having me.  I appreciate it.

By Landon Whaley, Editor of The Whaley Report