Why the rally is unlikely to last... The single best opportunity in the markets today... A no-risk 'call option' that never expires... One asset to own whether the market goes higher or lower from here...
If you've been with us for long, you know we're generally cautious on the market right now...
In short, as Porter has been warning since 2013, there have been significant – and growing – risks in the corporate-bond market. And the recent, sharp decline in stocks and high-yield, or "junk," bonds suggests the market is finally waking up to these risks.
Despite the recent rebound in stocks and bonds, we believe it's still too soon to say we're "out of the woods" just yet. As Porter explained in last Friday's Digest...
In regards to the overall markets and the risks I've been writing about (off and on) since May 2013... the clouds parted a bit this week. Domestic oil stocks have soared. For example, the Market Vectors Unconventional Oil & Gas Fund (FRAK), which holds a basket of shale-oil producers, is up 14% over the last 30 days, with most of the gains occurring this week.
Emerging markets bounced, too. The iShares MSCI Emerging Markets Fund (EEM) is up 7.5%. Even the Dow Jones Transportation Average Index showed signs of life, moving up almost 3%.
What hasn't bounced are high-yield corporate bonds. The iShares iBoxx $ High Yield Corporate Bond Fund (HYG) is still down 1.69% over the last 30 days. As long as corporate fixed income remains under pressure, I don't think the rally we've seen this week will last. If you're looking for a bottom to buy stocks, my advice is to keep watching high-yield bonds. U.S. stocks will struggle to rally in the face of higher borrowing costs.
Our advice remains the same...
| • | Stay long your "winners," but be sure to keep your "catastrophe-prevention plan" in place |
| • | Put new money to work only in the highest-quality opportunities |
| • | Consider shorting a stock or two to hedge your portfolio |
| • | Hold much more cash than usual |
Of course, as we always remind readers, no one can be certain where the market is headed next. It's possible this rally still has an "inning" or two left before it ends.
But we still believe this is a good time to hold more cash than usual...
This is because holding cash isn't just a bet that stocks and other assets will decline. It's a bet that better opportunities will come along.
In fact, as our colleague Dan Ferris explained in the October issue of Extreme Value, you can think of cash as a no-risk "call option" that never expires...
Typically in finance, call and put options give you the ability to buy or not buy, sell or not sell, at a range of price points. They're priced in a deep, active, liquid market. That makes it difficult to get them at bargain prices. Efficient pricing actually erodes the optionality, limiting upside and increasing downside. Expensive goods are like that.
Fortunately, there is a financial asset that perfectly captures the flexibility and value of optionality... It's better than call and put options. This asset's optionality isn't priced in a large, liquid market. There aren't millions of people trading its option value back and forth millions of times a day. The asset has no expiration date. And you aren't locked into buying or selling at a particular time.
The option I'm talking about is cash... When I say "cash" in this issue, I mean savings accounts, checking accounts, or any FDIC-insured account. The FDIC insures balances up to $250,000.
As Dan explained, most folks don't think of cash as an asset you "buy," but that's exactly what you're doing when you sell stocks, bonds, or anything else. And it acts as a "call option" on any asset you'd like to buy, with no pricing constraints, and no erosion of value over time (like traditional options).
Dan says investors would make a lot more money if they changed the way they thought about cash...
With stocks trading around 20 times earnings and junk bonds at small spreads over Treasurys (and starting to crack around the edges), cash is more appealing than the alternatives.
In other words, with most stocks and bonds trading at high valuations, don't hold cash just because you think the market might crash. Hold cash because you're practically guaranteed to find better opportunities down the road.
To understand why this is, Dan says you need to know the basics of "optionality." More from Dan...
Optionality is a simple and powerful idea. Generally speaking, optionality is the combination of huge upside and limited downside. That's different than most of the situations investors encounter. Typically, huge upside is accompanied by huge downside. Optionality limits your downside, while leaving you exposed to all the upside potential.
Cash's downside is virtually non-existent. There's no valuation risk, because you'll never pay more than $1 for $1 of cash. There's no market risk, because $1 will always be quoted at $1. There's no fundamental business risk, because cash is unlikely to succumb to competition. Everybody wants it, all the time.
Most investors misinterpret the upside portion of the optionality of cash. They might think the only financial upside is the tiny yield earned on short-term Treasury bills (around 0.01% today). But that's not the option value of cash. That's just the intrinsic value, which is limited. The optionality of cash is... the value of the successful investments you'll make in the future.
Again, even if you don't believe the market will crash, Dan says holding cash becomes more and more desirable as stock prices move higher...
The limited downside of cash stands in stark contrast to the rising risk and growing downside of an expensive market.
Risk rises and falls with price. The stock market gets riskier and future returns get lower as it moves higher. So... as stock prices go higher, holding cash gets smarter. Big upside. Virtually non-existent downside. That's the optionality of cash in a nutshell.
People who don't have plenty of cash to put to work when great ideas show up won't get rich. Ignore reality, forgo the substantial option value of cash, and buy expensive stocks at your own peril.
On the other hand, if the market does decline, holding cash is one of the easiest and best ways to reduce the risk to your portfolio. More from Dan...
Holding cash is by far the easiest, most reliable way to reduce risk in an equity portfolio. The more cash you hold, the less risk exposure you have. For most investors, holding a lot of cash seems like a mistake or a copout.
If it is a mistake, you will only pay for it with the unearned value of a lost opportunity. You won't pay for it with the loss of capital. It's guaranteed you'll lose some opportunities by holding cash – that's just the cost of the option value. But you won't lose money.
For Dan, the bottom line is simple...
Cash is a strategic asset that can be unleashed on any asset you desire. Its option value is substantially greater than the intrinsic value of Treasury bills or cash-savings accounts. If you don't understand that, you may behave impulsively and take on valuation risk or fundamental risk.
Be confident. Be patient. Hold your cash proudly. Brag about it at cocktail parties. Don't deploy it until you find a good business that's undervalued and not likely to stay that way for long.
As longtime subscribers know, Dan is a strict value investor. His Extreme Value advisory is dedicated exclusively to finding little-known stocks trading for far less than their intrinsic values. In other words, Dan only recommends stocks that are incredibly cheap and safe... literally the market's most "extreme values"...
So Dan's strict investment criteria may differ from yours, but his advice is applicable – and valuable – for all investors...
If you aren't finding many great opportunities to invest in today, there is little downside to holding a large part of your portfolio in cash until you do.
In the meantime, Dan has found one stock he's extremely bullish on today. He says it's hands-down the best opportunity he has ever found in his 18-year investment-advisory career. If you're not already an Extreme Value subscriber, click here to learn more about this opportunity.
New 52-week highs (as of 10/9/15): Activision Blizzard (ATVI), Expeditors International (EXPD), National Beverage (FIZZ), Altria (MO), and Constellation Brands (STZ).
If you're here with us in Las Vegas this week (or watching from home), we'd like to hear from you. Please send your thoughts and comments on the conference to feedback@stansberryresearch.com. We'll be publishing some of our favorite e-mails throughout the event.
Regards,
Justin Brill
Las Vegas, Nevada
October 12, 2015
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