How to Play the 'Melt Up' With Less Downside

How to play the 'Melt Up' with less downside... The power of the 'Golden Triangle' strategy... What happens when stock and bond investors disagree... A Golden Triangle example using one of Porter's favorite stocks... How we've done so far...

Editor's note: As we mentioned in yesterday's Digest, we're in Las Vegas this week for our annual Stansberry Conference and Alliance Meeting. So for the next couple of days, we're switching things up a bit...

Today, we're featuring an essay from Stansberry Research senior analyst Mike DiBiase. For those of you who aren't familiar, Mike has more than two decades of experience in the world of finance and accounting. He's a former certified public accountant ("CPA") who also holds bachelor's and master's degrees in accounting. Prior to joining us, he was vice president of finance and planning for a large, publicly traded software company.

These days, Mike leads the research efforts for Stansberry's Credit Opportunities, our distressed-debt advisory, which Porter gave an "A++" and an "A+" in the 2016 and 2017 annual Report Cards, respectively.

In today's essay, Mike discusses a way to capture the upside of the "Melt Up" while also protecting yourself from the ensuing "Melt Down"...

What if you could invest in the Melt Up without having to worry much about losing your hat when the market crashes?

Today, I (Mike DiBiase) want to share a strategy that lets you do just that.

Longtime Digest readers are familiar with the Melt Up. My colleague Steve Sjuggerud coined the term to describe the blow-off top that typically occurs in the final stages of a bull market.

Like Steve, I believe the stock market is likely to continue hitting new highs in the coming months. Some stocks could soar much higher than anyone believes possible. And no one wants to sit on the sidelines and potentially miss out on those kinds of life-changing gains.

But I'm not going to pretend that I know exactly how much longer this bull market will go on...

No one knows for sure. We can only make educated guesses.

One thing I do know for certain is that the party will eventually end. And when it does – like any party that goes on a little too long – all that will be left will be a giant mess... and a massive headache. No one is looking forward to that. Investors who ignore their stop losses could see their Melt Up gains disappear practically overnight.

My colleague and Digest editor Justin Brill regularly reminds you that if you aren't prepared for a market crash, you could be wiped out. He frequently suggests "hedging" your exposure to the Melt Up by holding some extra cash... adding a few short positions... keeping the bulk of your portfolio in high-quality, capital-efficient companies... and closely following your trailing stops.

But today, I'm going to tell you about something a little different. It's a way to participate in the Melt Up, while at the same time protecting you from some of the downside of a potential market crash.

We call it the 'Golden Triangle' stock strategy...

If you're not familiar, let me explain what it is and how it works. My colleague Bryan Beach and I discovered this strategy last year while we were researching corporate bonds. In short, we found a way to use the corporate-bond market to identify great stock investments.

The old market adage says that the bond market is smarter than the stock market. It's a bit of an investing cliché, but the bond market has certainly earned its reputation.

Unlike stock investors, bond investors are mostly institutional investors, like pension funds, hedge funds, and insurance companies. They can afford to hire armies of professionals with advanced legal, accounting, and finance degrees, who do nothing but study the markets and companies all day. They are generally better at spotting major market moves before stock analysts. That's why they're called the "smart money."

Our strategy is simple...

First, we look for stocks that are already cheap. Then, we use the bond market to find those that are poised to soar.

We start by looking for stocks that have collapsed quickly, falling at least 50% from a recent high over the past two years. Typically, we see this when stock investors have reacted to some company-specific bad news. They panic and head for the exits, just like they do in a stock market crash. Sometimes, the exodus might be warranted... But often, it's not.

We're looking to take advantage of the fact that the stock market – unlike the bond market – is emotional. Stock investors tend to behave with a herd mentality. Greed often causes them to chase stock prices up far too high. But the opposite is also true... Fear often causes them to sell stocks first and ask questions later. As a result, stock prices often fall much further than fundamentals suggest they should.

From this list of beaten-down stocks, we then identify the companies that have issued corporate bonds. That narrows the list a good bit, but it's critical. It allows us to use the bond market to identify those stocks that have sold off too much – and therefore have the most upside.

Finally, we look for situations where the company's bonds didn't sell off as the stock collapsed. That sends a clear signal. It tells us that a company's bond investors – unlike its stock investors – remain confident in its future prospects.

In other words, we're looking for setups where the company's stock and bond investors disagree...

The idea is that if the typically "cooler-headed" bond investors aren't worried, it's likely that the stock investors have overreacted. This small group of carefully vetted stocks is poised to soar.

We were shocked at the results when we back-tested this strategy... Stocks with this exact setup went on to more than double within two years, on average.

Take a look at the following chart. It shows the stock and bond prices of a representative index of more than 100 companies we studied where the bond market disagreed with the stock market...

The black line is the average stock price and the blue line is the average bond price (indexed to a beginning price of 100). The horizontal axis represents the number of months since the stock market first began to sell off these stocks.

By now, you can probably tell why we call it the 'Golden Triangle'...

The chart of the stock and bond prices looks like a triangle. The first side of the triangle is the vertical gold line, which represents the divergence between the stock and bond prices (i.e. stock and bond investors don't agree). The second side of the triangle is the horizontal straight gold line at the top, which shows the price of the bond never straying far from par. And the third side of the triangle is the steadily rising stock price.

In practice, we want to buy these stocks when a triangle is just starting to form. Like Steve, we're looking for an uptrend before jumping in.

You can think of it like this: The typical Golden Triangle stock fell 60% to $40 a share. Within two years, it was trading around $89 a share. That's 11% below the pre-fall levels... But it's more than a double from its lows. After two years, these stocks were up 123% on average.

Of course, that's just the average. Some did much better than that. Almost every stock where the bond market disagreed showed a gain two years later. And nearly two-thirds of the stocks doubled within two years. Remarkably, we didn't even try to pick the best stocks of the group.

The beauty of this strategy is that you don't even need stocks to Melt Up for it to work. The stocks just need trade back to their previous levels to double.

This strategy is ideal for a time like today, where you might be worried about a stock market crash...

By starting with companies with Golden Triangle setups, we're already ahead of most investors, because these stocks' downsides are far lower than with typical stocks. Remember, we're buying stocks that have already crashed. A lot of the negative sentiment is already priced into them. So in a market crash, they have much less room to fall.

Now, I'm not saying these stocks can't trade lower. They can, especially if the stock market crashes. But by definition, these stocks have a tremendous advantage over most other stocks in that they aren't trading at nosebleed valuations or near all-time highs.

But more important, you still get all of the upside of a Melt Up with these stocks. They're poised to soar. Remember, stock investors overreacted to some bad news. And our back-testing shows that these kinds of stocks more than double on average within two years. These stocks can do well even in the face of a bear market.

Take capital-efficient homebuilder NVR (NVR), for example...

Back in 2006, fears of a housing slowdown cut its stock price in half in the span of three short months. Its share price fell from $840 a share that April to less than $400 by July... erasing $2.4 billion from its market cap.

It was an extreme overreaction. The company was in great financial shape. On sales of $6 billion that year, it generated free cash of nearly $700 million. That's why NVR's bond investors weren't worried at all. NVR's bond continued to trade near par, just as it always had.

It was a perfect Golden Triangle setup. If you had bought NVR shares near its bottom at the end of July 2006, you would have doubled your money in less than a year. NVR's stock rose to more than $800 by April 2007.

We all know what happened in 2007 and 2008... The subprime mortgage crisis led to the bankruptcy of Lehman Brothers in September 2008. From the market's peak in October 2007 through the bottom in March 2009, the S&P 500 collapsed by more than 50%.

But if you had bought NVR's shares at the end of July 2006 – when the Golden Triangle started to form – and held on to your shares through that collapse, you would have fared much better than the overall market. At the end of 2009, the broad market was down 6%, but NVR shares were up 44%. You would have weathered the worst financial crisis in the U.S. since the Great Depression. Take a look for yourself...

This shows why the Golden Triangle strategy is so powerful. It's a way to invest in good companies trading at great prices.

We introduced the Golden Triangle strategy in Stansberry's Credit Opportunities and made our first recommendations in that newsletter last December.

Each month in Stansberry's Credit Opportunities, we publish a list of every company that has a Golden Triangle setup. But we don't recommend all of them. We want to do even better than our back-tested results.

So we roll up our sleeves and learn why stock investors rushed for the exits. We look at each company's revenues, profit margins, and cash flows, and where they're headed. We size up the competitors and industry trends. Then, we only recommend the strongest companies.

So, how have we done so far?

Since our first recommendations last December, we've added a total of 10 Golden Triangle stocks to our model portfolio. Because we hold all of these positions with 35% hard stops to protect our capital, we were forced to close out of two of the recommendations early with losses. Including these two closed positions, we're up 12% on average, with an average holding period of a little more than five months. That's an annualized gain of 27%.

That might not sound like much, but it's nearly double the return of the overall stock market. If you had instead invested in the S&P 500 instead of these 10 positions, your annualized gain would only be 14%.

That's a great start... But we expect the results will be even better over the next 18 months. We know from our back-testing that this strategy can take time to play out over two years. Not all stocks go up immediately, but eventually, most do. And the vast majority go on to double within two years.

Already, one of our recommendations is up 69% in less than six months. In fact, six of our 10 Golden Triangle recommendations are already on pace to double.

With the Melt Up well underway and the possibility of a market crash looming, these are the exact types of stocks you should consider adding to your portfolio. If you're interested in learning more about our Golden Triangle stock strategy, you can learn more about it right here.

New 52-week highs (as of 10/1/18): Automatic Data Processing (ADP), Becton Dickinson (BDX), Cisco Systems (CSCO), Fidelity Select Medical Technology and Devices Portfolio (FSMEX), Intuitive Surgical (ISRG), Microsoft (MSFT), Nvidia (NVDA), Roku (ROKU), ProShares Ultra Health Care Fund (RXL), and Viper Energy Partners (VNOM).

In the mailbag, a reader compliments senior analyst Matt Weinschenk's Monday Digest and Porter responds to a disappointed Alliance member. Whether you're attending the 2018 Stansberry Conference in person or tuning in from home, we'd love to hear what you think so far. Send your notes to feedback@stansberryresearch.com.

"Dear Stansberry Research, I just finished reading tonight's note from Stansberry Research. It was extremely well written, provocative and entertaining. I'd like to hear more from this fellow! I work as much as I can, so I won't be able to attend your Las Vegas conference, unfortunately. I attended one you had in Nashville several years ago, and I was very much impressed. Keep up the good work!" – Paid-up subscriber Terry S.

"I was frankly disappointed that my Alliance membership promised no additional investment beyond a yearly renewal. I was not expecting to be charged for access to this conference material. I can understand charging for attendance since the space is limited and you have costs to cover. I am here in Las Vegas but choosing to attend only the 'no additional cost' Alliance day." – Paid-up subscriber Joel B.

Porter comment: Joel, sorry that you were disappointed.

I hope you'll understand that in addition to our publishing business, we have a live-events business. Our Stansberry Conference series has been in existence for many years and predates our Alliance subscription offer.

We can't offer lifetime subscriptions to live events (and never have), because the cost of producing these events makes that kind of an offer impossible to scale. Additionally, many of our speakers enforce their copyright protections on their live performances. It's simply a very different business than producing our own investment research from our own staff.

However, as we have always done, we will continue to provide the Alliance membership with a one-day conference and opportunity to network completely for free. And that's exactly what we promised to provide.

Regards,

Mike DiBiase
Las Vegas, Nevada
October 2, 2018