Masters Series: Lusting for a Bear

Editor's note: S&A founder Porter Stansberry recently has been sounding the alarm, warning readers that key market indicators are warning of an imminent downturn…

The correction Porter foresees would be painful for those who are unprepared… but as he explains in the following excerpt from the April 2008 issue of Stansberry's Investment Advisory, smart investors recognize big bear markets are also opportunities…

Written during a moment of optimism between the 2007 collapse of the subprime market and Lehman Brothers' 2008 failure… the piece identifies a few simple steps investors can take to protect themselves – and profit – when the market turns…

Lusting for a Bear
By Porter Stansberry, founder, S&A Investment Research

Learning to truly enjoy bear markets – to lust for them – is not easy.

Especially for novice investors, the idea of putting more money to work in bad markets makes about as much sense as running into a burning building. Nevertheless, as I'll show you, you have two very good ways to make big gains during bear markets, while positioning your portfolio for huge profits once the bull returns.

In my career as an investment analyst, I've seen at least a half dozen bona fide bear markets. The first three occurred during the emerging-markets meltdown of 1997-1998, which began in Asia with the Thai baht devaluation.

I was covering Hong Kong for a global macroeconomic research firm at the time. The index fell from around 17,000 to less than 6,000 in about six months. Stocks became so cheap that the government of Hong Kong began buying them – and it made a killing, too. Since no one was interested in Asian stocks anymore, I was assigned to Latin America... just in time for the wave of selling to spread across the Pacific. Shares of Telebras, the telecom monopoly in Brazil, the largest stock in my universe and the largest emerging-market stock in the world, fell by 75% over the course of six months. The whole disaster culminated in the Russian debt default of August 1998.

By the bottom, around October 1998, hundreds of relatively high-quality emerging-market stocks were down 90% or more. Thai blue chips sold for less than two times earnings! But no one would buy them.

I have a few poignant memories from those radical bear markets...

I remember vividly – I can even remember where I was sitting at the time – reading a well-known investment newsletter in August 1998. The writer had been famously bullish on Asia since 1994 or so. Basically he'd bought right at the top. He had been particularly bullish on Malaysia and Singapore. And his letter had become very popular, allowing him to launch a money-management business in addition to the letter. This guy had all of his readers and most of his funds under management in Asia... and he was getting killed, starting in 1997.

Then, in the midst of the Russian default, the leader of Malaysia reacted to investors trying to sell by imposing capital controls, which made it impossible for investors to get their money out of Malaysian stocks. The resulting panic sent prices down to about 95% off their highs.

Amid this utter devastation, this writer sent out one of the most incredible letters I'd ever seen. Sell everything, he said. He was throwing in the towel. Reading the letter, you could tell the bear market had destroyed this poor guy. He'd bankrupted his subscribers, lost most of the money he was managing, and knew he'd spend the next several years getting sued (which is what happened). At the time, I shared an office with Steve Sjuggerud. After reading the letter, we both looked at each other and said, "That's the bottom... "

If you'd bought Asian stocks when he told his readers to sell, you would have made a fortune. Judging by the most widely traded Malaysian index fund (EHM), Malaysia bottomed in August 1998 at $1.38. Only 18 months later, the index had rebounded to more than $6 – a 334% profit. And that was the index! Individual stocks went up far more – like 10 times and 20 times.

One more memory from those incredible days...

I took a research trip to Argentina and Brazil in the summer of 1998. I spent a week in Buenos Aires and a week in Sao Paulo. Young investment bankers showed me around both cities. Three things shocked me: the motorcycle drivers, the prevalence of prostitution (I was young and naïve...), and how you could buy every single stock in Brazil for less than four times earnings.

If I'd only had the capital and the conviction I have now, I would have bought every single blue-chip stock in Brazil. If only I'd put $10,000 in a dozen companies back then!

To give you an idea of how lucrative that might have been, since 2002, the iShares Brazil index fund (EZW) has gone from $5 to $88. This fund didn't exist in 1998, but if it had, it would have traded for less than $2. I believe you would have made about 50 times your money over 10 years if you'd bought Brazil in 1998. That's how you turn $100,000 into $5 million.

I was there. And I could have done it – except I didn't have the capital or the confidence to believe what my brain was telling me. I won't make that mistake again, believe me...

These bear markets taught me that stock prices can fall farther than anyone can imagine and, if you're patient, it's possible to make stupendous profits in stocks, especially if you're willing to buy when no one else will. These lessons helped me avoid staying long tech stocks during the 2000 meltdown. By the time 2002 rolled around, I was net short stocks in my letter, helping readers earn 20% gains on average in the year U.S. stocks cratered and finally hit bottom.

You'll probably say I got lucky when I called the exact bottom in the U.S. market in October 2002 and began buying heavily for the first time since 1999...

It wasn't luck. Stock prices had simply reached the point where we could safely buy the highest-quality stocks in America – like Exelon, which we've owned since that October 2002 issue. We bought the most efficient producer of electricity in America and the largest nuclear energy operator for 10 times earnings. You had to be dumb not to buy Exelon at that price. But, after a dozen years studying markets around the world, the one thing I know for certain is: Most people will only buy stocks when they shouldn't and will absolutely not buy stocks when they should.

If I can convince just one subscriber to ignore his emotions, forget his fears, and buy high-quality stocks when they're cheap – and ignore everything else – I will have accomplished something important with this letter.

With the S&P 500 down 24% from its peak to its recent trough, we are in the midst of a real bear market. My belief today is stock prices – on average – are going to go lower. Perhaps even much, much lower. Yes, I know I said last month I was bullish. I was reacting to the panic I could sense in the market.

Now, just as suddenly, complacency has returned – and that's dangerous. I don't think we've seen the "throw in the towel" moment. The public still largely believes in idiotic investment strategies, like index funds and super-high-cost hedge funds. People continue to contribute almost blindly to their 401ks. And a majority of U.S. households own equities. These things will change before we truly hit bottom. And that might take a long, long time.

While most of your financial advisors will undoubtedly tell you to trim your exposure to stocks and "batten down the hatches" financially – you will get the opposite advice from me.

Do you think Warren Buffett, Sam Zell, Marty Whitman, Bill Gross, Jim Rogers, Jeremy Grantham, Steve Leuthold, Mark Mobius, or any other extraordinarily successful long-term investor trims his portfolio during bear markets? Absolutely not. That's when they put their cash reserves to work.

Great investments are made during bear markets. Great investors earn their reputations during bear markets. The fortune you hope to gain from the markets will be made by what you do during bear markets. It's easy to buy and hold during good times. It is much, much more difficult to put money to work in critical situations when you have to go against the crowd and your own fears.

To my knowledge, there's only one way to do the right things during these critical times: You must know how to evaluate equity values. And you must understand the margin of safety you have in your investments. Without this knowledge, it is nearly impossible to sit on your hands and hold on. If you don't have firm knowledge of the value of your stocks and confidence in their intrinsic value, you will eventually cave in to your fears. You'll join the panic – at exactly the wrong moment.

But... if you know the value of what you own and if you're confident in the "margin of safety" in your investments, you should have absolutely nothing to fear.

You should adopt two other strategies during a bear market. First, don't ignore our "short sell" recommendations. Even if you only have two or three short positions, the gains in these speculations will help offset any temporary declines in your high-quality value stocks. If you've never sold a stock short before and you're uncertain about it, talk with your broker and try shorting just a few shares. Make sure you're comfortable with a small transaction before you try a larger one.

Second, even if you've never done it before, talk with your broker about selling covered calls. It's unlikely stocks, in general, are going to end this year up. But you can still do very well holding high-quality stocks while selling calls to generate income. The risk premium in the market is high right now, which means you can make 15%-20% a year selling calls against your core positions.

If you'll do these few, simple things – buy value, hedge at least some of your portfolio with short sales, and sell covered calls for income – you can prosper during the bear market, while you wait for the perfect moment of panic to arrive. And... if you'll do these things, you'll learn to love bear markets. We're being given a fantastic opportunity to build a super-high-quality portfolio at prices that almost guarantee we'll see high average returns over the next several years. All we have to do is be selective and patient – the things most investors can't do.

Now, if you can understand why fear and bear markets are truly good for us, you'll be excited to learn that the financial crisis will almost certainly get much worse... and that you can protect yourself.

Regards,

Porter Stansberry

Editor's note: Eight months after writing the above piece… Porter published the first work that would become his landmark "End of America" analysis of the currency crisis facing America. The video created to relay his controversial work become one of the most-watched financial presentations ever, attracting more than 20 million views.

Earlier this year, Porter updated his End of America research and released a new video describing how he expects the scenario to unfold from here. To watch the video, click here.