One of the greatest anomalies in the market today...
Editor's note: We're continuing "training week" with a discussion of one of Porter's favorite trading strategies...
In Stansberry Alpha, Porter takes advantage of one of the most popular market fallacies to produce outstanding returns... Since launching the service in November 2012, Porter and his team of analysts have achieved an impressive 74% win rate. The average return on margin for each trade is 28% – that's 45% annualized.
For today's Digest, we're adapting a piece Porter wrote back in June. But before we discuss Porter's Alpha strategy, we'll cover what's happening in the markets...
Inflationary pressures are still gripping the economy...
In the December 19 Digest, Porter explained that despite a slowdown in Europe and a rout in commodity prices (resulting from the loose-money-financed glut in production), inflation is still prevalent...
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The ongoing financial boom is a folly of historic portions. Nobody knows exactly when, but eventually, the world will lose faith in central banks' ability to boost markets.
But they're certainly trying today...
We told you about Japan's massive stimulus program in the November 5 Digest... giving the Bank of Japan (BOJ) the ability to buy every new bond the government issues.
Japan can't meet its 2% inflation target. The latest numbers for November show consumer prices increased 0.07%... well below expectations.
Even with the massive amount of stimulus measures, Japan can't get its economy out of the low growth/deflationary mode.
As Porter described above, the end results of Japan's stimulus efforts are a dramatically weakened yen and soaring asset prices.
Since Prime Minister Shinzo Abe called for unlimited monetary easing in November 2012, the yen has weakened nearly 50%. As you can see from the chart below – of the dollar-to-yen ratio – the yen has weakened significantly against the dollar...
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The BOJ managed to send asset prices soaring... significantly weakening the yen's purchasing power.
So far, the BOJ has pushed the yield on Japanese 10-year bonds down to 0.32%. (For comparison, the U.S. 10-year bond yields 2.22%.) Japanese stocks are up 70% since the beginning of 2013.
Abe has succeeded in destroying his country's currency and boosting the stock market, but he's still not seeing inflation... so he continues to ease.
Abe recently won an overwhelming reelection victory. He has a mandate from the Japanese public to continue stimulus.
According to the New York Times, Japan plans to cut the overall effective corporate tax rate to 32.1% by April – a drop of 2.51 percentage points – and then to 31.3% the following year. Abe pledged earlier this year to drop the corporate tax rate to less than 30% in coming years to beat Japan's ongoing deflation.
Last Saturday, Abe's government announced a new stimulus package of 3.5 trillion yen ($29.1 billion) stimulus to subsidize the country's poorer regions and households.
Japan has the stimulus throttle to the floor... and it's not about to let up. But it isn't the only country looking to inject its monetary system. Worldwide central bankers faced with policy limitations (like extremely low interest rates) are struggling to find "creative" ways to stimulate.
China, which is struggling with slowing growth, is also on the easing train...
The country is broadening its definition of a "bank deposit." Now, funds held at non-deposit-taking institutions will be considered a bank deposit... which means Chinese banks will soon have more reserves and can make more loans against those reserves.
This move alone means an additional $800 billion will become available to lend, according to Xinhua News Agency, the official Chinese news source. Said economist Dariusz Kowalczyk, "Beijing is trying to stimulate lending and they are trying not to use strong measures."
Due to industrial overcapacity and a housing slump, China is expected to grow at its slowest pace this year since 1990.
Even with more funds available for lending, there's no guarantee that people and businesses will seek new loans. The latest data from the Bank of China said demand for bank credit was at its lowest level since the financial crisis in 2008.
Interest rates will likely come down in China to boost demand... sending more money into the stock market.
That's good news for Steve Sjuggerud's long-China thesis. The Shanghai Composite Index is already at its highest level since January 2010. True Wealth subscribers have made 42% in three and a half months on Steve's top China investment... And more gains are likely on the way thanks to market stimulus.
Elsewhere, people's faith in central bankers will be put to the test yet again in Greece.
We've long written about Europe's economic woes. And now, Greece is on the verge of another collapse. The country will hold early elections after Prime Minister Antonis Samaras failed in a third (and final) attempt to get enough support for his presidential candidate.
The International Monetary Fund (IMF) and European Central Bank (ECB)'s bailout package is now jeopardized. Greece's extreme left party – SYRIZA – is ahead in the polls... and said it will not honor the austerity terms and may even default on the debt.
As a result, yields on Greek 10-year bonds spiked to 9.26%. The IMF said it will suspend financial aid to Greece until it forms a new government.
Should Greece default, billions of dollars of Greek bonds would get crushed. Those losses would cause a huge ripple effect throughout the global banking system.
The incentive is to keep Greece paying... which gives the country leverage to gain some concessions in bailout terms... which will depend on who is elected to renegotiate.
ECB head Mario Draghi will now have to take this new set of circumstances into consideration before deciding how to engage in a new round of quantitative easing... or end up with devalued bonds on the ECB's balance sheet.
There's still a lot of fear and uncertainty in the world. In fact, the market's "fear gauge" just flashed again... And Porter is taking advantage of it again in Stansberry Alpha. Each of his five previous "fear trades" has ended up profitable. From the December issue of Stansberry Alpha...
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Stansberry Alpha subscribers can get the full details of the trade... But we'd like to tell you a bit about Porter's trading service... and the strategies behind it...
As I mentioned in the beginning of today's Digest, Stansberry Alpha is based on one of the most prevalent fallacies in the stock market: The efficient-market hypothesis.
Professor Eugene Fama developed the hypothesis at the University of Chicago in the 1960s. He argued that no one can consistently beat the market because prices on traded assets already reflect all publicly available information... It soon became the conventional wisdom on markets...
It's a great theory, except it's not always true...
The efficient-market hypothesis offers a kind of symmetry... a balance. The market knows all and accounts for everything... It is always in balance, at equilibrium.
It's comforting... but the real world doesn't work like that.
Asymmetries are found in almost every part of the natural world. Take your body, for example. Your left lung is smaller than your right lung – it's missing one whole lobe. Your lungs are built this way because your heart is asymmetrical, too.
The world frequently doesn't work exactly like the models suggest it should. Asymmetry is actually the norm, despite the human preference for symmetry.
And that got us to thinking... there has to be a way for regular, individual investors to take advantage of asymmetries.
That's where the anomaly we've discovered comes in...
The Alpha anomaly gives almost any investor... at almost any time... on almost any stock he wants to own... the opportunity to invest with lower risk and earn profits that are far greater than what's possible by just owning the stock outright.
If you use these ideas in the right way... you can produce hundreds-of-percent profits routinely and safely. But... if you're careless, lazy, or greedy with these ideas... they will destroy your savings.
You should only use these techniques on high-quality companies (companies with either great brands, great assets, or both) that are deeply undervalued.
You can make a lot of money with these ideas, but they will produce volatile results. To handle this kind of volatility, you will need proper position sizes.
So, if you can't accurately value the business, if you aren't certain of what it's worth, or if you don't have enough capital to maintain the position at less than 10% of your portfolio – don't do the trade.
The Alpha strategies involve using options. If you want to make really large gains, you must use options.
The key to success is never to pay for them.
We'll walk through an example of how it works using the MGM recommendation from the December 2012 issue of Stansberry Alpha and structure it as a Stansberry Alpha trade.
At the time, it was a great investment opportunity. The company owns most of the major hotels on the Las Vegas strip and was trading at a favorable valuation.
So... how did they turn this opportunity into a killing?
In the December 2012 issue of Stansberry Alpha, Porter and his team recommended selling a put option on the stock with a strike price of $10 that expired in January 2014. A put option is nothing more than a promise to buy 100 shares of stock at a fixed price ($10, in this case) for a certain period of time (until January 2014).
The main advantage of selling a put – of merely promising to buy the stock instead of actually buying it – is leverage. To allow you to sell this option, brokers ask for a deposit that assures you can meet your potential obligation. (The amount of leverage you can get depends on your broker, but the legal minimum is only 20%.) With a strike price of $10, investors only had to put up $2 per share. And this is hard to believe, but it's true... other investors were willing to pay us $1.36 in exchange for this promise to buy the stock.
In our view, selling a put is less risky than buying a stock. It requires less capital (in deposit). And assuming you pick a strike price that's below the market, your effective "buy-in price" will be lower than the price of the stock at the time of your trade.
In this case, instead of buying MGM shares at $11, they were promising to buy at an effective price of $8.64. You calculate our effective "long" price by simply subtracting the fee you got in exchange for selling the put from the strike price ($10 – $1.36 = $8.64). Buying a stock at $8.64 a share is less risky than buying the same stock at $11 a share. Thus, selling puts allows us to take less risk, but in a leveraged way.
The main problem with merely selling puts is that it's too safe. Yes, they were earning $1.36, while only putting up $2. That's an instant return of 68% – but they were only earning that return on a sliver of their capital. If the stock took off like Porter's team expected, they were giving up a lot of potential upside. They don't have enough capital in the trade and they don't have an unlimited upside position.
To capture more of that upside, they spent a portion of the cash they had received for selling a put (called the "premium") to purchase a call option. A call option is the opposite of a put option. It gave them the right (but not the obligation) to sell 100 shares of stock at a fixed price for a fixed period of time.
In this case, they recommended buying a $15 call on MGM that also expired in January 2014 for just $0.57. This gave them the option of opening a 100-share position in the stock at $15 a share. Of course, they would only exercise that if the stock traded for more than $15 by January 2014.
As you can see, it costs almost nothing. And it requires zero deposit. Considering that even after buying this call option, they were still getting $0.79 in net premium for our promise to buy MGM (39.5% return on invested capital), consider that a nearly free option.
It's not actually free... but the point is... Porter believes you should never buy an option unless you've found a way to finance it. And when you can earn an immediate return of nearly 40% on the capital you've tied up in this trade and get a call option... then the call is close enough to free.
After Porter's recommendation... MGM's stock did well. After about six months, it was up more than 50%. In June 2013, they decided to take some of their profits off the table, mostly because they grew concerned about the U.S. corporate bond market (which was crashing). In hindsight, they sold much too soon. But even so, let's look at what happened.
First, they never had to put any additional capital into this trade. The stock never traded for less than their $10 strike price. Thus, they never got a "margin call." To close the position, they had to buy back the put they'd sold. The price of the put had fallen to $0.22, leaving them with a net premium of $0.57 per share (after accounting for the cost of the call option they bought). That's a reasonable 28.5% gain in about six months.
The big gains came from the call option... They sold the call option for $1.81 per share. Keep in mind, they got this call option essentially for free. They generated all of the cost ($0.57) when they sold the put. So in total... on a $2 cash investment... they earned a net premium of $0.57 and a call-option profit of $1.81. That's a total return of $2.38 – a 119% return on their $2 cash investment in only six months.
In dollar terms, let me show you how this might have worked in a real portfolio. Let's assume you have a $100,000 portfolio. Putting $2,000 into this trade (on margin) would have allowed you to sell 10 put contracts on MGM at our recommended $10 strike. (Remember, each contract covers 100 shares.) That's only 2% of your entire portfolio.
But this trade is using 20% margin, which means your total potential margin requirement is $10,000. That's 10% of your portfolio. You're within our recommended risk boundaries. If your portfolio is smaller, then you simply sell fewer put contracts. (With a $50,000 portfolio, for example, you would sell five contracts as a maximum position size.)
To sell the 10 contracts, you'd give your broker $2,000 in cash. He'd immediately hand back to you $1,360 in put premium, from which he'd take another $570 to purchase the $15 calls. You'd start out the trade up $790 – almost $800 in the black. That offers you a considerable "margin of safety" – an instant return of 40% on the capital you've invested in the trade.
Realize, like in a real estate deal, if you are forced to meet a margin call, your return will decrease. That's why it's critical that you limit your trading only to deals where you can have a tremendous amount of certainty in the underlying value.
To close out this trade, you would have bought back the put option you sold earlier – but it only cost $0.22 per share to buy back. On 10 contracts, that totals $220. Thus, you earned a net option premium of $570 on your $2,000 investment in only six months. That's nearly 30%. That's a great return. But it's not the real "juice."
The big gains came from the call option, which you were able to sell for $1.81 per share. On 10 contracts, that's $1,810. To find your total return, you simply add the money you made on net premium ($570) to the money you made from the call option ($1,810). If your calculator works like mine, that's a total return of $2,380 in about six months on an investment of $2,000, or nearly 120%.
Simply buying the common stock can be very profitable... but as they demonstrated... Alpha is an even better – and safer – way to invest in these companies that lowers your risk... and increases your upside potential.
New 52-week highs (as of 12/29/14): Cubist Pharmaceuticals (CBST), Cempra (CEMP), Cisco (CSCO), Dominion Resources (D), Express Scripts (ESRX), iShares Core S&P Small-Cap Fund (IJR), Kinder Morgan (KMI), PowerShares Buyback Achievers Fund (PKW), Rent-A-Center (RCII), ProShares Ultra S&P 500 Fund (SSO), Target (TGT), UIL Holdings (UIL), ProShares Ultra Utilities Fund (UPW), and Walgreens (WAG).
Regards,
Sean Goldsmith
December 30, 2014
