We Haven't Seen All-Out Panic... Yet

Why being optimistic can make you a better investor... It pays to be bullish over the long term... With higher returns comes higher risk... Signs of panic... The bears' case... We haven't seen all-out panic... yet... Don't miss next week's Bull vs. Bear Summit...

It pays to look on the bright side...

An optimist envisions a positive future. When something negative happens, an optimist sees it as a temporary setback.

Besides making you more enjoyable to be around, being optimistic comes with some important perks.

For example, evidence suggests that optimists live longer...

In 1991, researchers began a study of 1,000 elderly Dutch men and women. The subjects had a physical exam and completed a survey. Then, the researchers grouped them into quartiles and categorized the lowest quartile as the "pessimists" and the highest quartile as the "optimists."

During the nine-year follow-up period, the researchers found that the optimists were 55% less likely to die from any cause than the pessimists. They were also 23% less likely to die from a heart-related illness.

Optimism doesn't merely have a positive effect on your health... It can also improve your investment results.

A stock market optimist – or "bull" – expects stocks to rise and believes that sell-offs are only temporary setbacks.

Over the very long term, I (Alan Gula) am bullish, as every investor should be...

The Credit Suisse Investment Returns Yearbook is an authoritative source for long-term returns. Economics professors Elroy Dimson, Paul Marsh, and Mike Staunton research and write it. The first edition, published in 2002, was even titled Triumph of the Optimists.

Indeed, the optimist has the wind at his back... According to the 2018 Yearbook, the U.S. stock market has produced an annualized total return (including reinvested dividends) of 9.6% since 1900. In real terms – adjusted for inflation – U.S. equities have returned 6.5% per year for more than a century. That's a healthy, real rate of return... and shows why nobody should be a perma-bear.

But why does the stock market give us these generous returns? The most common answer has to do with risk.

For asset classes, higher risk means higher returns...

As anyone reading today's Digest knows, the stock market allows us to own a fractional share of a company. Assemble a diversified portfolio, and you have a small ownership interest in Corporate America.

Of course, these assets come with risk. And stocks are near the extreme end of the risk spectrum...

U.S. Treasury bills – short-term, government-issued debt – are among the safest (and therefore, lowest-yielding) financial assets. Treasury notes and bonds have more time to maturity (up to 30 years), so they're riskier than Treasury bills. Still, dating back to 1900, long-dated Treasurys have returned 4.9% on an annualized basis... about half the return of stocks.

Corporate bonds are riskier than Treasurys because they come with the added risk of the company defaulting. And stocks are even riskier because equity holders rank lower than debt holders in a company's capital structure.

In short, stocks compensate shareholders with a high return because of the relatively high degree of risk. That's a simplified explanation. Let's look at things from a different perspective...

If you've been with us for long, you know we often say that 'you can't fake cash'...

Free cash flow ("FCF") is the cash that's left over after accounting for a company's operating expenses and capital expenditures ("capex").

FCF doesn't lie because it's harder to manipulate than earnings. As renowned economist Alfred Rappaport once said, "Profits are an opinion, cash is a fact."

FCF is also integral to creating shareholder value. The market value of a company is essentially the present value of all future FCFs (or at least the market's expectations of future FCFs). Therefore, it stands to reason that if FCF grows over time, a company's share price will as well.

Back in 1999, right before the tech bubble burst, total FCF for companies in the S&P 500 Index was about $370 billion. Last year, S&P 500 companies generated nearly $1.3 trillion in aggregate FCF.

Said another way, over nearly two decades, U.S. large-cap stocks have increased their combined FCF by about 250%. Around half that can be attributed to inflation. But the rest of that increase in FCF is due to innovation, smart capex decisions, and overall economic growth.

Sometimes, the market overestimates or underestimates future FCF. But as long as the economy continues to expand... companies innovate, creating new products and markets... and corporate managers invest wisely to meet demand and grow revenues... then Corporate America will produce more and more FCF over time.

As a result, we should be bullish over the long run. Our default stock market view should be optimistic.

Furthermore, there are times when we should be more bullish – usually when most investors become fearful.

Last December, we began to see signs that investors were panicking...

Regular readers know that put options (or "puts") can act as a hedge. If you own a stock, you can buy puts to protect your downside. Even if you don't own the underlying stock, you can use puts to speculate on its decline.

Either way, buying puts is a way to express a bearish view. Generally, fewer put options are traded than call options (or "calls"), which are a bet on a stock's upside (when bought). But sometimes, investors and traders become so bearish that put volume exceeds call volume.

That's exactly what we saw at the end of last year, when the S&P 500 dropped 9% in what was the worst December since the Great Depression.

The bearishness was reflected in the CBOE Equity Put/Call Ratio, which measures the relative trading volume of puts and calls. The ratio spiked to 1.13 on December 21 – its highest reading since December 2015, and one of the highest readings since early 2007...

I told my Stansberry Alpha readers about this last month. It's what we like to see when we recommend our options trades, because it's a bullish sign for stocks.

The signal was prescient... Since the ratio's late-December highs, the S&P 500 is up 12%.

Still, the bulls would have liked to see even more panic. At the previous put-buying peaks in late 2015 and early 2016, the ratio was higher than what we saw in December.

Basically, investors were panicked, but not "go to cash in your retirement accounts" panicked.

Not only that, but I also see a massive warning sign...

The bears have good reason to believe the market could be approaching another serious decline...

As I mentioned earlier, corporate bonds are riskier than Treasurys due to the potential risk of a default. Because of this risk, corporate bonds yield more than risk-free Treasurys. The difference in yield is known as a "credit spread."

Credit spreads fluctuate based on how bullish or bearish credit investors are. When investors are bullish, the spread narrows. When they get nervous, it widens.

Spreads for BBB-rated bonds in particular are worth keeping an eye on, since more than half of the companies in the S&P 500 fall into this credit tier. Take a look at the following chart of BBB spreads...

In January 2018, BBB-rated bonds yielded just 1.17% – or 117 basis points – more than Treasury securities of similar durations. That was the narrowest spread since mid-2007. At the same time, the S&P 500 surged out of the gates. Both the credit and equity markets were having a "fear of missing out" moment.

Then came a volatility shock, causing stocks to fall 10% in only a few weeks. But the stock market proved resilient, rallying into the summer before peaking in September.

Take another look at the previous chart... You'll notice how BBB-spreads were wider in September than they were at the beginning of 2018. That was a negative divergence. And the credit market was right to be more cautious, given the turmoil to come shortly thereafter.

Credit spreads have narrowed in the past month, but they're still far wider than they were at the beginning of 2018... meaning that credit risk appetite is waning.

Furthermore, BBB spreads haven't yet widened to 300 basis points – a level reached in late 2011 and again in early 2016. We haven't seen an all-out panic in the credit market that would suggest we're at the beginning of another multiyear rally in stocks.

In other words, while the stock market bulls are gaining confidence, the credit market is growing more bearish... And the credit market is usually right.

I'm not here to tell you whether to be bullish or bearish right now...

Clearly, an argument can be made for either side. And I'm personally far less bullish than I was at the beginning of the year.

Fortunately, our friends at our corporate affiliate TradeSmith are hosting the Bull vs. Bear Summit next Wednesday, February 13 at 8 p.m. Eastern time to help sort things out.

You'll hear from my colleagues Dr. Steve Sjuggerud and Dan Ferris, as well as TradeSmith founder Dr. Richard Smith, former hedge-fund manager Whitney Tilson, and more. You can save your seat for this free online event by clicking here.

New 52-week highs (as of 2/7/19): Equity Commonwealth (EQC), Essex Property Trust (ESS), New York Times (NYT), O'Reilly Automotive (ORLY), Sandstorm Gold (SAND), and W.R. Berkley (WRB).

In today's mailbag, a subscriber weighs in about the importance of investing in high-quality, capital-efficient businesses. As always, send us your comments and questions to feedback@stansberryresearch.com. Remember, we can't provide individual investment advice. But we do read every e-mail.

"Happy February, Yes, my capital-efficient stocks are already my main focus of my investing plan since I stopped out of my other positions this Fall. I'm finding myself to be more proficient as a trader so will continue to use Steve's Commodities and Melt Up portfolios as trading portions of my account. There's no room to safely go 'all-in' and having high-quality, capital-efficient businesses in my long-term investment plan enables me to focus on the portion that I'm trading with." – Paid-up subscriber Jeff S.

Regards,

Alan Gula
Baltimore, Maryland
February 8, 2019