The S&A Digest: Buy on Panic, Don't Sell on Serenity

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/28/2013

Ian's latest quant work… Trading steel mills for casinos… Good news for two Phase 1 picks… Borrow from a Canuck…

You probably heard something about Jeremy Grantham (the famed value investor) proclaiming that the entire world has become a "bubble." Today, our quant analyst Ian Davis looks to the numbers to see what that means for long-term investors. Don't miss his research, below.

We hope you enjoy Ian's number crunching as much as we do. We're fascinated by his work, which is based solely on statistically valid correlations. Ian's max value analysis is the kind of system we think investors should follow, instead of buying index funds. If you missed Ian's earlier work, I highly recommend you read more about his strategy here. For his subscribers, Ian has been expanding on his system, using it to find the best buys among U.S. sectors as well as international markets.

You've got to be kidding…

"More than a decade after its towering blast furnaces went cold, Bethlehem Steel's flagship plant is being transformed into a $600 million casino complex run by Las Vegas Sands Corp., owner of the Venetian Resort Hotel Casino in Las Vegas." – USA Today

They're building a casino in Bethlehem, Pennsylvania, on the site of one of America's most important steel mills! This is where the girders for the Golden Gate Bridge were built… You don't have to be an economist to believe replacing value-added industrial plants (which transform iron ore into bridges, battle ships, and automobile frames) with casinos (which transform statistically illiterate people into statistically illiterate poor people) is a bad idea.

For those of you familiar with financial history, these fundamental changes to the landscape of our economy aren't all that surprising. The rise of gambling, speculation, and debt – and the corresponding decline of thrift, industry, and production – have long been associated with civilizations that debase their currency. Inflation devalues long-term investments, is an impediment to saving, and makes it impossible to predict international trade flows – all of which are necessary for the health of industrial plants. In the past, inflation-caused losses in productivity have been dealt with by empire building and plunder. Sounds familiar, doesn't it?

Good news for Phase 1 recommendation Idenix (IDIX)… The European Union today approved SEBIVO, a drug that treats chronic Hepatitis B in adults. The approval applies to all 27 EU members and should take effect in the second quarter of 2007. Idenix gained 7% on the news.

More from Phase 1… Sangamo Biosciences (SGMO) entered an agreement to provide Genentech with technology to produce protein drugs. Financial terms were not disclosed, but shares of the biotech company gained 4% in early morning trading. Readers have made 38% since last May.

S&A Oil Report pick Eni (E) will buy Dominion's (D) Gulf of Mexico operations for $4.8 billion. Eni, which produced 1.769 million barrels of oil per day last year, expects the deal to add 74,000 barrels per day of production.

Sjuggerud Confidential pick Opteum Financial Services (OPX) will sell its money-losing mortgage-origination business. Opteum lost $22 million since the subprime blowup. Readers are up about 25% in less than a month.

Japan, South Korea, and China are on schedule to produce so many vessels that shipping rates for coal and iron-ore freights, currently at an all-time high, are expected to fall 40% by 2010.

Aerospace and defense company Honeywell (HON) leads the Dow Jones Industrial Average year-to-date with a 21.3% gain. Caterpillar (CAT) holds the No. 2 spot with a 20.3% gain.

Canada overtook China as the fastest-growing global lender. Canada's commitments to a balanced budget, low interest rates, falling currency against the euro, and a law that allows pension funds to own as much foreign debt as they would like without a tax penalty are all attracting debtors.

And the mailbag… While we certainly appreciate all of the S&A advisory board applications that we've received, we are also reminded of Warren Buffett's comment that if you tell the world you're looking for a poodle, a lot of people will send you a cocker spaniel…

While we will look at all of the resumes we've received, the five or so invitations to join our board of advisors will only be sent to folks who have several decades of business success under their belt. We're looking for people who know a lot about how their industries work, so that we can use them as sources for our research. We're also looking for highly qualified, experienced investors.

Our perfect candidate is 65 years old, has 30 years of experience in the same industry, and has risen from the bottom to the top. A person like this knows enough about business to help us build ours. We've also never met a successful businessman whose company we didn't honestly enjoy: Business is a humbling obsession. We'll continue to accept applications through the end of the day tomorrow. We hope to have our board in place by June 30. The term is one year. The retainer is $10,000.

If you're interested, or you think you might be, please send us a note or a resume. We're judging your experience, not your prose. All correspondence regarding our advisory board to this address, please: feedback@stansberryresearch.com.

"Porter, the thought of you being responsible for the health, wealth, and proper upbringing of another human being frightens me like nothing else! Congratulations, Pop!" – Paid-up subscriber Charlie Leckinger

"I made my first options trade. Used a stock that you suggested would be good to hold, so I was willing to hold it if the option didn't pan out. I made just over 20% on my investment in three weeks and only wish I had had the courage to invest more. Could have made more if I had held it longer but I wanted my first trade to be a good one. Thanks is all I can say." – Paid-up subscriber Lloyd

Porter comment: Courage shouldn't be a part of any investment strategy. Fear and caution are both far more useful.

"I've had an epiphany. I'm a value investor, period. I'd rather get to the destination in my tortoise shell than on the fleet feet of a rabbit who is the aim of every hunter (investment pitfalls). It's tough to let Phase 1 go, but I'm more at home with Ferris, Sjug, and you. I love a special situation such as you three often uncover – the gains are as exciting as anything in Phase 1 (almost). I'd rather risk time than money, rather suffer the sin of omission than the sin of commission (as you wisely pointed out). Of course we must commit, but the downside of investing with you three (except for when Sjug gets out of his element) is usually quite limited and the upside substantial. It's taken me almost a year to hit my stride with S&A, but I think I've found it. There is something for everyone at S&A – maybe a little bit too much. But the smorgasbord is filled with exciting little boring tarts, ready to pop in the oven for maximum taste." – Paid-up subscriber Jim Pursley

Porter comment: That's a valuable epiphany. Finding the right investment style is half the battle.

"How do you propose clients to make money grabbing dividends? As I understand it, the special dividends are considered 'return on investment' so the stock price adjusts to make up for the loss of capital. I had thought about buying puts to capture the downward move, but the strike price of the puts are also adjusted to take away the opportunity. So what gives with the recommendations? What is the strategy? If you can show me how to bat 90% and make real money, I'll sign up." – Paid-up subscriber Allen Cooke

Porter comment: We've gotten more questions about our S&A Dividend Grabber strategy than any product, ever, in the history of our publishing company. This stuns us, because the strategy is so simple to understand. At the heart of it is a very simple truism: The stock market tends to value businesses on the basis of their earnings. Ergo, when quality companies pay out large cash dividends that they can afford, this shouldn't reduce the company's market price. But, as you correctly point out, the day after a large dividend is paid, a stock's price will always decline substantially – usually by the full amount of the dividend. We make money by recognizing that, more often than not, a company's intrinsic value hasn't declined by nearly as much as the dividend that's been paid. In time then, we expect the stock price of a company that meets the Dividend Grabber criteria will return to its pre-dividend level. As far as proving that it works, simply look at our track record, which is currently one of our best.

"You guys can slap my hands later but here's my 'grabbing' story… Dean Foods gapped up on opening ex-dividend. Not to be totally unexpected, I guess. I couldn't get it at the price I wanted so I had to get a little creative. I looked at the calls and they, too, were more expensive than I cared for. However, the puts were very inviting, and that's where I went. Sold the puts. No money out of pocket and, with your theory of recovery, very low risk. I took them off the table Wednesday after recovering 58% of my money at risk. Pretty nice return, guys. I know you don't recommend playing it in that manner, but in this case, it worked." – Paid-up subscriber John Fritchey

Porter comment: Once you recognize and understand the huge advantage you have because of the mispricing of stocks following a large dividend, there are many ways to "skin the cat."

"Couldn't some of the S&A Top Ten Open Recommendations replace some on the S&A Hall of Fame list?" Paid-up subscriber V. Smith

Porter comment: We'll see. To be in our Hall of Fame, a stock must be sold and the profits booked. Until that point, all profits are merely a figment of your imagination…

Regards,

Porter Stansberry

Baltimore, Maryland

Buy on Panic, Don't Sell on Serenity

By Ian Davis

"The risk premium has reached a historic low everywhere." So wrote legendary value investor Jeremy Grantham, in his first-quarter letter to clients this year.

Grantham and his firm, Grantham Mayo Van Otterloo, invest $141 billion for many wealthy clients, including Vice President Dick Cheney.

In Grantham's letter, he urges caution to his investors, arguing that world markets are entering a bubble phase more widespread than any other in history. Although this may be true (and Grantham gives numerous interesting points to back up his theory), I believe the current market still has significant room to run.

Take 1998, for example. Risk premiums were extremely low, stocks were expensive, and capital was widely available. However, if you exited the market in 1998, you would have missed one of the largest rallies in the history of the Nasdaq.

Investors today are almost completely unafraid of risk, but that doesn't mean the market is going to crash.

Risk Premiums at Historic Lows

Today, I'm going to focus on three main measures of risk: the emerging-markets spread, the high-yield spread, and the VIX volatility index.

In the case of the emerging-markets spread, the Lehman Brothers Emerging Market Bond Index is yielding only 1.5% more than 10-year U.S. Treasury Bonds. This tiny spread is only slightly above its all-time low of 1.48%.

As for the high-yield spread, the Merrill Lynch High Yield Master II Index is yielding only 2.94% more than U.S. Treasuries (more than one-third below the median spread of 4.5%).

Finally, the CBOE Volatility Index (^VIX) is currently 33% below its historic median level.

All three of these measures are at or near all-time lows, meaning investors aren't getting paid for the large risks they're taking on.

So What Does All This Mean to You?

In order to analyze how much U.S. investors love (or hate) risk, I developed the Serenity Index, which tracks the emerging-markets spread, the high-yield spread, and the VIX.

After analyzing the performance of the S&P 500 index versus the Serenity Index, I found that when people panic – causing risk premiums and volatilities to soar – the U.S. equity market tends to perform well in the following 12 months.

The following table shows the performance of the S&P 500 12 months after the serenity index falls to a panic extreme. As you can see, stocks often do well following these high levels of investor panic.

However, in the opposite situation, when investors are serene, the market does not necessarily fall in the subsequent months.

The following chart shows the serenity index versus the S&P 500. As you can see, investors can remain serene for very long periods of time. While in these serene modes, the market tends to undergo a slow, steady growth. When risk premiums finally rise and the Serenity Index falls, a market crash does not necessarily follow. In fact, on numerous occasions, the market has broken out in a new leg of its rally.

Investor Serenity is Not a Good Sell Signal

Conclusion

Since investors are unafraid of risk, we are clearly not in a panic situation. Therefore, bargains in the equity and bond markets may be hard to find.

However, since investors can remain serene for long periods of time, and rising panic doesn't necessarily lead to a crash in U.S. markets, I believe there is no reason to be worried about your U.S. positions just yet.

Good investing,

Ian Davis

April 30, 2007

Stansberry & Associates Top 10 Open Recommendations

Stansberry & Associates Hall of Fame