A lesson in knowledge and patience...

A lesson in knowledge and patience... Washington prepares for capital controls... The real deficit number... A simple way to value the bond markets...

In today's Friday Digest... I'll give you perhaps the clearest example I've ever found of the real problems driving our "End of America" theme. And... here's a first... a detailed explanation of why you shouldn't buy high-yield bonds right now. With our usual caveat – there's no such thing as teaching, only learning – firmly in mind, let's get right into the most depressing numbers we've seen in a long time. We hope you're in the mood to learn something useful...

This week, USA Today published a fact we never thought we'd see published in any other publication, much less a national newspaper. Here is it...

The current average, per-household income in the United States is $49,000 a year. The U.S. actual, real deficit, according to existing accounting standards, totaled $42,000 per household last year... or just a little more than $5 trillion.

"Wait a minute," you say. "I heard on the NBC Nightly News with Brian Williams that the deficit was 'only' $1.3 trillion. Where did you come up with that $5 trillion number, Porter?"

Unlike every other institution in the United States (and just about every other government in the world)... Congress exempts itself from normal accounting standards. Specifically, it doesn't include the cost of future retirement benefits. If any other institution in the U.S. – including corporations, state governments, local governments, or banks – did their accounting this way, they would go to jail.

But the U.S. Congress... That bastion of decency, tradition, and stature... the place where our national future is charted... where our credit and honor are housed? Nope. It doesn't have to include any of those expenses. And so the public is routinely lied to... every year... by every major media outlet... including even my wife's favorite TV anchor, Brian Williams. But maybe that's finally changing...

As you know, we have been writing about this issue for a long time. We've been warning people specifically that even if you collected all the income in the country – even if taxes were 100% of income – we'd still likely be running a deficit.

To us, this is the single most shocking fact of our national debt crisis. It completely blows away the idea that if we just would raise taxes a little we could solve the budget deficit. You can see why that's nonsense. When you know the real numbers, you know what trouble we're in... and you know the only viable solution is cutting the size of government by a huge amount.

It's a solution that none of the major candidates have even mentioned. And they will never implement it. That's the main reason we're so worried about the future of the dollar. We believe it is politically impossible to reduce spending in Washington D.C. We believe the only politically acceptable solution to these problems is to borrow and print... more and more... more and more...

That is, of course, what various democracies have done, time and time again. This kind of inflation will destroy the middle class, by weakening its wages (in real terms) and suffocating our economy with taxes. It can also lead to a true panic, where everyone tries to flee the currency at the same time. That's the real risk... and it grows bigger and bigger every day.

Lots of people have accused us of making up facts like this one... and trying to scare people by talking about the risk of major capital flight. Well... USA Today just published the same figures. Still think we're making up the numbers?

And just this week, two of the most powerful U.S. congressmen – Barney Frank and Sander Levin – released a letter they'd sent to U.S. Treasury Secretary Tim Geithner, expressing their concerns over future U.S. free trade agreements if the government doesn't address capital controls. The headline of the letter is: Frank and Levin Call on Administration to Clarify Position on Capital Controls.

As a U.S. citizen, I'd expect my representatives in Washington to be warning the administration that any attempt to restrict my freedom to use the currency to buy assets or make investments would result in the most severe consequences, both politically and economically. Thus... looking at the headline of the letter... I'd hoped that was the position taken by Reps. Frank and Levin.

But is that their concern? Are they worried about the future value of the U.S. dollar? Are they worried about their constituents' economic freedom? Not at all. Says the letter...

The congressmen specifically state they want additional power to restrict the flow of capital into and out of the United States...

Perhaps no other two points of fact in our End of America reporting have been as hotly debated. First, lots of people have accused us of greatly exaggerating – essentially lying about – the scope of the ongoing fiscal deficits. And two, we've faced nearly unanimous opposition to our warning that capital controls are certainly going to be placed on Americans. As I've written many times... by the time Obama leaves office, you will not be allowed to buy gold or to exchange the U.S. dollar freely into other currencies.

No irony is richer than the kind that comes from Washington. The left-wing media is actually celebrating this letter from Frank and Levin as a positive development. The spin is that most other countries have the ability to implement capital controls and that they're the key to solving a financial crisis. They even cite Iceland as a positive example. I'm not making this up. See for yourself here...

If your goal is to destroy the economy, wipe out the savings and the wages of almost every American, and steal trillions of foreigners' investment dollars, Iceland is a great example. I... just... can't... make... this... stuff... up...

And it scares the hell out of me that my fellow Americans are stupid enough to endorse this kind of madness.

Let me reiterate these two key warnings. This isn't going to happen in the future. This isn't a problem for our grandchildren. This is happening right now.

Sure, Europe's problems have center stage today. But our problems aren't going away. They haven't changed at all. They are getting worse, day after day, month after month.

How bad is it getting? Just consider this. The unfunded liabilities for Social Security and Medicare grew by $3.7 trillion last year. That's more than our entire federal budget. Does this make any sense to you? How many years in a row could you afford to borrow your family's entire budget? The federal government's debts – both its cash debts and its unfunded liabilities – now total $561,000 per household. How many people do you know who can afford this extra burden?

How can we possibly afford these public debts when record numbers of Americans can't even afford their private debts? On average, we owe $116,000 for private debts, per household. Remember, average income is a little less than $50,000.

These problems aren't solvable, given our political structure. We are a totalitarian democracy with precious few civil rights. We have no protection from confiscatory taxation or capital controls (judging from Frank and Levin's letter). As a result, we do not truly live in a country with the rule of law or even real private property. These realities remain mostly hidden from view... It is only if you study the finances of our government... only if you watch for the hidden laws and edicts... that you see a nation that's printing and borrowing itself into bankruptcy. And our government is setting up the equivalent of financial martial law to try and deal with the outcome.

Whether you believe me doesn't really matter anymore. The proof is mounting so high, even the most dedicated big-government backer can't dismiss it. I can't tell you when the dam is going to break. But that doesn't mean it won't. It most certainly will. And that day is getting closer and closer.

For the last several years, you've seen me urging every subscriber to learn how to invest in high-yield corporate bonds. I've told you repeatedly that most investors should never buy stocks at all... that they should only buy corporate bonds.

My reasoning is sound: Corporate bonds are far less risky than stocks. They generally pay out more in income. And it's relatively easy to make more money in bonds than in stocks, most of the time. These things are all still true. But as with the stock market, some times are better to buy corporate bonds than others. And we're drawing near the end of a big window to buy them. Let me show you...

This chart has a lot going on, so please, let me walk you through it. First, the black line is an index of high-yield corporate bonds. It shows you the average price level of these bonds. You can think of the line as the S&P 500 for the bond market. But that's a bit misleading because, unlike stocks, the prices of bonds shouldn't change all that much. Bond investors get paid mainly via annual coupon payments.

As a good rule of thumb, you should also get at least 10% a year to lend money to an average business. You'll notice that when legendary investor Warren Buffett lent money to companies like Harley Davidson and Goldman Sachs during the financial crisis of 2008 (when capital available for borrowing suddenly vanished), he insisted on an annual payment of 10%. Follow his lead.

I put the black line in the chart so you could see when high-yield bonds have been the cheapest to buy over the last dozen or so years. You can see they hit bottoms twice – once in 2002 and once in 2009.

Now... let's talk about the blue line. The blue line shows you the "spread" – that's the difference – between the average yield on high-yield corporate bonds and the 10-year U.S. Treasury bond. Everything in the financial world is relative. Yields are high or low based on the 10-year U.S. Treasury yield. That's because the U.S. Treasury market is the world's largest debt market. We measure the value in these corporate bonds by measuring them against the 10-year U.S. Treasury bond.

You can think of the blue line the way stock investors think of a price-to-earnings (P/E) ratio. And just like you want to buy stocks (in general) when the P/E says they're cheap, you want to buy bonds when they're offering you a wide spread over U.S. Treasurys.

You can see that the spread was wide back between 2001 and 2003. Bonds purchased during those years would have paid out yields well in excess of 10%. Likewise, another big window to buy high-yield corporate debt opened during the crisis of 2008. That was the best opportunity of my entire life to buy high-yield corporate bonds. At one point, the average returns available exceeded 20% a year, even for long-dated (10-year) corporate paper. Buying at moments like these will make you very, very wealthy. As many of our True Income readers know, those investments were simply epic.

Finally, we get to the advanced portion of understanding this market... The gray line that runs across the chart shows you the average spread over 10-year Treasury bonds. The average for the last 12 years has been 640 basis points (6.4%). In other words, if U.S. Treasurys were yielding, say, 4%, on average, the expected yield in the high-yield corporate bond market would be 10.4%.

You want to time your purchases for when the spread is the widest. One way to help you toward that goal is to only buy high-yield bonds when the existing spreads are way above average. I'd say you want to avoid buying until the average spread is at least 25% higher than average, or 835 basis points. Today, the average spread is 668 points. That's just barely above average.

Just as with buying stocks, if you're learn to be more disciplined with buying bonds, you'll do much better over the long term.

So... what are we doing now in True Income? We're still holding many of the high-yield bonds we bought at great prices from a few years ago. And now, we're adding investment-quality bonds to the portfolio. These bonds are lower yielding – averaging about 7% or so – but their earnings can cover their interest payments by a much greater margin than typical issuers of high-yield corporate debt.

These bonds are a whole different animal. No, you won't make as much buying them, and they usually don't outperform stocks. But... and this is important... you shouldn't lose any money with these bonds. They're a safe place to park your savings while you wait for better opportunities in the stock market or the high-yield bond market.

The hardest part about becoming a top-notch investor is learning that what makes you rich is knowledge combined with patience. Very, very few people have both. I hope you'll be one of them.

There is no better place to park your cash right now than investment-quality bonds. And in True Income, you can make 7% returns with little volatility... Plus, it's much safer than the stock market. Before you scoff at 7% annual returns, consider that Buffett only expects the market to return around 5% a year for the next few years. That's considerable outperformance – without the risk of a major downturn we could experience in the stock market.

Many subscribers write us saying they're scared to buy bonds... They've never done it before. Don't worry. It's easy. Just like buying a stock, you simply call your broker and tell him the CUSIP number (which is like the ticker for a bond). And in True Income, we tell you exactly what to say to your broker to buy a bond. In past Digests, I've said learning to buy corporate bonds will "literally change your life." I believe that. Once you see how easy it is to make great income in bonds, you'll have a hard time going back to stocks.

We're currently offering all subscribers the opportunity to try True Income for one year for free. We're also offering a one-year subscription to Dan Ferris' Extreme Value, perennially one of our top-performing services, for free. Together, that's a $3,400 value. Plus, we're offering 10 one-ounce, 99.99% pure silver coins.

We're giving these three gifts as part of our Private Wealth Alliance. As a Private Wealth Alliance member, you will receive subscriptions to five of our best newsletters for life, plus everything I described above, for less than what you would pay for a one-year subscription to True Income. It's one of the best offers we've ever made. And there's no better way to test a subscription to True Income. To learn more about the Private Wealth Alliance, click here...

Please note: In observance of the Memorial Day holiday. The Stansberry & Associates offices will be closed Monday, May 28. We will not publish the Digest that day. We'll resume our regular publishing schedule on Tuesday.

New 52-week highs (as of 5/24/2012): ProShares UltraShort Euro Fund (EUO) and Wal-Mart (WMT).

In the mailbag... a true rarity. I give a detailed and useful answer to a good question about how to sell options profitably. Don't press your luck by asking reasonable questions. You know what we prefer half-crazed rants blaming us for all of your investment mistakes. Send yours to feedback@stansberryresearch.com.

"Where is Mike Williams? No offence but Mike and True Income is my favorite subscription. It seems that this month's suggestion is too vanilla. Projected return of 27% pales in comparison. Little to no capital gains." – Paid-up subscriber Mark Taylor

Porter comment: Mike Williams is no longer with Stansberry & Associates. We parted as friends, and we wish him the best. We don't make substantive comments about changes to our staff because all personnel issues touch directly on the privacy of our employees.

In the short term, Dr. David Eifrig is going to oversee the letter – he's certainly qualified. Meanwhile, we are also conducting a thorough search for a skilled, experienced credit analyst to help with our research.

We know Mike's shoes will be hard to fill... But we have an ample budget to find and hire the right guy. If you'd like to throw your name in the ring, please reach out to us via the feedback e-mail address. Our ideal candidate is a retired professional fixed-income investor, who still has a passion for the markets. We'd expect to see at least 10 years experience as a principal at a firm that invested in corporate debt. We offer a lucrative wage and the ability to work from anywhere in the world that has a reliable Internet connection.

As for this month's investment choice... we have to take what the market gives us, as I attempted to explain in the essay above. As with so many of our other advanced strategies, buying high-yield bonds at the wrong time (or at the wrong price) can be a horrible strategy.

We catch a lot of flack for not warning enough about the risks of these bonds (and of other advanced strategies, like selling puts). We know it's not possible to please everyone. We simply try to publish the information we'd like to have, if our roles were reversed. Done with a little bit of common sense and experience, investing in high-yield corporate bonds offers individual investors the best combination of risk to return. That's especially true if you're someone who requires income from his portfolio for living expenses. That's why we will continue to publish this information... while warning people about the market conditions as appropriate.

"I have recently become a flex alliance member, and I have been trying to make heads or tail of this True Income advisory, and I find it impossible. Mike Williams needs to give far less information about why he is telling us to buy something, but to give exact instructions on what to buy exactly (these CUSIP numbers are very difficult to discern), when to buy it, how to buy it, etc. I don't give a crap why he is recommending it, I can't figure out all his codes and numbers. I am not a bond specialist. He needs to explain in plain English, and give much simpler instructions. That is why you guys can't sell True Income to people. It is too complicated!" – Paid up subscriber Richard Pitera

Porter comment: I have to admit... This one made me chuckle. I wonder what's difficult about reading a CUSIP number? It's simply the same thing as a ticker symbol for a stock.

Bonds are not difficult to buy. You call a broker. You tell him what bond you want to buy and give him the CUSIP number. You tell him what you're willing to pay and how many bonds you want to buy. He rounds up the bonds and calls you back with the exact price. You tell him "OK" or "No, thanks." That's all there is to it.

From there, your coupon payments are directly wired into your brokerage account. If you decide to sell your bonds, you do the same thing in reverse. Call your broker. Get a price. Make a decision if you're willing to sell.

The real problem in most cases is... no matter how many times we explain all this... most people are simply not willing to pick up the phone and try it. Everyone hates to do something new – especially with money.

Once again, I suggest you start small. Try buying just one bond. See how it goes. Learn the process. Do it with such a small amount of money that it's no longer scary. Even if you never buy a bond again, knowing how to do so will be empowering and make you a more experienced investor. Don't reject our advice out of hand, simply because it's "not for you." How could you know that if you've never tried it?

Oh... by the way... we offer all True Income subscribers a detailed special report on exactly how to buy bonds – whom to call, what to say, etc. Alas... it's still next to impossible to get anyone to read it. But good news for Mr. Pitera: Our last bond recommendation trades on the New York Stock Exchange with a plain three-letter symbol. It's literally no different from buying a stock. Hopefully, he'll be pleased.

"In last Friday's S&A Digest, Porter mentioned that we are in a secular bear market. One of the things he mentioned that we can help offset the declining P/E multiple is to sell covered call options. I struggle with covered calls because I'm giving up any capital gains above the strike price – while I absorb any losses. I would appreciate some guidelines for the type of stocks and specific market conditions where I would sell covered options. I'm hoping to for the general guidelines along the lines I have read numerous times for selling naked put options, ie: high VIX, and only sell puts for companies you want to own and at a price you would be happy to pay." – Paid-up subscriber Ron Karney

Porter comment: Ideal stocks to sell covered calls against are high-quality firms that offer large, ongoing dividend payments. To offset the risk of being called away, use covered calls to cash in on stocks that you might otherwise have simply sold.

Take Wal-Mart, for example. If you bought shares during last year's summer swoon, you might have paid $50 a share. Now, Wal-Mart is a great business and you would have no problem continuing to hold it. It pays a reasonable dividend and buys back a ton of stock. Last year, the company returned a total of $11 billion in capital to its owners, producing a combined yield (buybacks and dividend) of around 5% at the current price.

While Wal-Mart is a great business... its shares are not as cheap as they have been. The stock is sitting at new high of around $65 per share. We just downgraded it from a buy to a hold in my newsletter. So you're sitting on a capital gain (30%!) on a stock you're happy to hold for a long, long time.

That's the setup you want to sell a covered call. Now, remember two rules. First rule: Never sell an option (either a put or a call) on a stock you aren't happy to own for the long term. Don't allow yourself to be drawn into high-premium shares that are risky. That's the sucker's bet. Repeat after me: Only sell options on the safest stocks.

Second rule: Only sell calls if the strike price is one you're happy to collect if you're required to sell the stock.

In this case, imagine Wal-Mart shares rose to $70 by the end of this year. That would be a 40% capital gain in about 15 months. That's a good return on a safe stock. You'll die a rich man taking profits at those levels. What would be better?

How about collecting a call premium on top of the $70? Today, investors are offering $1.50 for the right to buy Wal-Mart at $70. That would net $71.50 if you were called away. That bumps up your capital gain to 43%. And including the cash dividends you would collect while you wait, you're probably looking at total returns on the stock of about 48%-50% in just over a year. That's a great trade. It's hard to do better.

Now... if you get called away from Wal-Mart at $70, are you truly disappointed? Could be. You'll have to pay taxes on the gains. And you'll have to buy the stock back at some point (assuming you want to own it for the long term). Selling calls will over time and on average reduce total returns. But... it will also increase income, substantially. For many investors, giving up a few points of total return to increase income is worth it. Also, as you become more experienced, you'll get better at not getting called away. And that makes the income free.

For long-term investors who do not want the risk of being called away from the stock, selling a put is another way to generate income. But... instead of focusing on the stocks (like Wal-Mart) that have done well lately, you want to sell puts on super high-quality stocks that have done poorly.

Take JPMorgan, for example. This might be too risky for some, but I doubt JPMorgan is going to fail or would even be allowed to tumble much more than it already has. The shares have been clobbered. It's fallen from $46 to $34 – a decline of 26%. Assuming you'd be happy to buy the stock at $34, you can earn an extra $1.53 right now just by promising to do so through mid-June. That might turn out to be a bad bet in the short term. (If Europe gets worse, JPMorgan will surely continue to suffer.) But if you're a long-term investor in the stock, getting paid to add to your position at a reasonable price will definitely increase your total returns over time.

In general, I recommend selling puts on positions you intend to continue building and selling calls on positions you're ready (or at least willing) to sell. I also recommend doing most of your options selling during periods when the Volatility Index (the "VIX") is above 25. That's shouldn't happen very often... But given the large financial problems in the world today, I think you'll get these kinds of opportunities regularly. You can go out longer in duration during these periods too.

My best advice: Start small. Do a few small trades to learn the ropes. The more experience you get, the better. And never forget: Opportunity is infinite. Capital is finite. Learn to wait for the right setups. Never feel forced to trade. Success comes from knowledge and patience.

Regards,

Porter Stansberry

Baltimore, Maryland

May 25, 2012