Buffett says "buy"

Buffett says "buy"... CNBC says "sell"... Can stocks fall below zero?... More fallout from AIG... How we're making a fortune selling puts... S&A conference call now available...

It's the single most incredible thing I've ever seen in all my years in the markets. People are now so desperate for insurance (puts), they're paying prices that assume stocks could fall to less than zero. More on this below...

Also, if you'd like to listen to an hour-long discussion of the markets among Steve Sjuggerud, Dan Ferris, Jeff Clark, and me, just click here.

Sjug made a few great slides that show where we are now as compared to the last 100 years or so. And we all give away a few of our top ideas... for free.

Warren Buffett wrote an opinion piece in the New York Times today explaining why he has taken 100% of his personal account out of government bonds and begun to buy U.S. stocks. He reminds investors to "Be fearful when others are greedy, and be greedy when others are fearful." According to Buffett – the greatest investor of all time – stocks will undoubtedly beat cash in the next decade.

While Buffett was warning investors in the late 1990s to stay away from stocks, the guys on CNBC were shouting at people to buy tech stocks. Remember? Now that Buffett says it's time to buy, the guys on CNBC this morning were telling people to stay away from stocks that Buffett can afford to take a risk on, but most Americans can't. Who should you believe?

When Lehman Brothers still existed, the bank had around $150 billion in debt. And the Securities and Exchange Commission let hedge funds and other investment vehicles take $365 billion of insurance out on that debt through the use of credit default swaps. It was like buying life insurance on someone you knew was going to die soon. Now the sellers of these swaps are on the hook for $365 billion. And guess who sold most of the Lehman swaps? AIG.

When the history of this debacle is finally written, AIG will be at the center of the story. AIG sold insurance on hundreds of billions of dollars of assets, with almost no collateral. It, along with Fannie and Freddie, was the primary reason so much credit was created and the primary reason so much credit has been destroyed.

China's sovereign wealth fund, China Investment Corp (CIC), is planning to increase its position in Blackstone Group from 9.9% to 12.5%. CIC will buy shares on the open market at a steep discount to its original entry price. Blackstone shares are now trading for less than $10. CIC originally paid more than $29 a share – a small discount to its initial public offering price. You already know how we feel about government-led investment funds.

"Sean," I asked our marketing manager this morning, "did we get any subscribers to Put Strategy Report?" Silence. He looked down.

"Uh... It's not going very well."

"Sean, I know. It's not your fault. Just tell me..."

"We got five subscriptions..."

I'd have a bigger audience for my new Put Strategy Report if I were teaching a high-school class instead of writing to one of the largest financial subscriber lists in the world. I understand the hesitation: People are scared, and selling puts is something most people don't do. And the fact is, I'd normally never recommend selling a put option – ever.

But right now, pricing in options is absolutely insane. If the market for puts were regulated, it would be against the law to sell puts for such high prices. People are insuring stocks at prices that assume a company like Bank of America could eventually be worth negative $30.

No matter how bad things are, stocks will never be worth a negative number. And yet, right now, people are buying insurance on stocks (puts) at prices that assume the stocks will actually go to less than zero. Meanwhile, no matter how carefully I explain the situation, no matter how clearly the facts are on my side, I can't get anyone to take this advice... by far the most lucrative and safest advice I've ever given in my entire career.

Let me show you a trade we did this week...

On Monday, I recommended selling $15 January 2009 puts on Bank of America. That means: If Bank of America fell to $15 or below, we would have to buy the stock – at $15. We were providing insurance (through January 16, 2009) to holders of Bank of America so they couldn't lose any money below $15. At the time, the stock was trading around $23. Thus, for our puts to be exercised – for our insurance to be put in force – the stock would have to fall another 31%.

We got paid $2 per share for these options, which will expire in three months. In other words, if Bank of America's stock doesn't completely collapse in the next three months, we keep $2 per share – almost 10% of the value of the stock itself! If you look at the price of these options, the implied volatility of the stock is 180. The price of this insurance is so high, it implies there's a risk that the shares of Bank of America could decline by 180%. That's impossible.

I don't know how long this situation will last. But there's nothing better, financially, than playing a game that's set up so you can't lose. I'm going to keep recommending trades to the handful of subscribers I've got. So far, I've made four recommendations. They're all doing great. I believe it's impossible for us to lose a penny on any of these trades and I guarantee we'll make at least 50% on our money over the next year. I'm going to keep shoving this idea down your throat because it's exactly what you ought to be doing right now. And no else is going to bother to explain it to you.

One more thing... We'll make money selling these puts even if the stock market declines. Why? Because this extreme pricing simply can't last. The index that tracks the prices of options is known as the VIX. When the VIX exceeds 50, it is an extreme situation. It has only gone above 50 18 times. (It has never before gone above 80 – like it did yesterday.) And it never stays so high for long. On average, when the VIX has risen past 50, it falls by 81% over the next month.

So as the panic fades, the opportunity to sell puts at absurd prices will pass. As the prices on our puts fall 50%-80%, we'll be able to buy them back without having to wait until they expire. We'll make a killing in the next few weeks. To learn more about my Put Strategy Report, the best way for you to make money in the markets right now, click here.

New highs: short sale of Gannett (GCI).

In the mailbag, lots of opinions about selling puts. "It'll be a disaster," says one. And several great questions about the strategy. Send your comments and predictions here: feedback@stansberryresearch.com.

"Porter – I have been making a good profit for 10-12 years selling put options. I have never had a losing year. My philosophy is to sell options on good stocks that I don't mind owning when they are down... I am currently trying some of your recommendations. Thanks for a great service." – Paid-up subscriber Elmer McCormick

Porter comment: Having one reader is better, slightly, than having none at all.

You must have two things when you sell a naked put. One, you must want to own the stock you're going to insure. You might end up having to buy it, so you may as well want to own it. Second, you need enough investment acumen to know what the stock in question is actually worth. As long as you're selling insurance for far below intrinsic value, it's very difficult to lose money.

On all of the puts I've recommended selling, our strike prices are so far "out of the money" that I think we have a less than 5% probability we'll end up buying the stock. But if it happens, we'll pay less than half of intrinsic value.

"I am a great fan of Porter. I deeply sympathize with his political perspective, his courage to speak his mind, and believe that he has had a brilliant year with several great calls. That being said the Put selling idea is a disaster. Yes, it may work, but the risk/return characteristics are terrible. Even with huge implied volatility the actual premium you can receive is very small unless you take an outsized underlying position. However, if you do you run an enormous risk if the stock falls. If the stock rises you will still make less than if you took a lower risk position by just buying the underlying stock. You are supposed to maximize you gains while minimizing your loses. Put selling does the opposite.

"What you should be doing is buying stock and selling call options. Here you are limiting risk, taking advantage of extremely expensive volatility and have great risk/return characteristics in a very difficult market. Porter, I am a great fan and could not have asked for better analysis from anyone this year, but please recognize that this strategy provides a bad risk/return and potentially leads devastating losses that are very difficult to control. A position that accelerates against you when it goes wrong is extremely difficult for anyone to handle emotionally; objectivity gets thrown out of the window. Otherwise thank you again for your wonderful analysis this year." – Paid up subscriber Chris Belchamber

Porter comment: Chris, thanks for your thoughtful critique. Under normal circumstances, I'd likely agree with you. As you know, I've been recommending selling calls on my "No Risk" portfolio of stocks most of this year, generating income to offset the declining prices of stocks.

So why switch to selling puts? Prices for far-out-of-the-money puts have gone to levels we have never before seen. We're able to earn 15%-20% premiums quarterly, simply by agreeing to buy stocks at completely ludicrous prices. For example, my most recent recommendation, which I sent out this morning, was to sell a $10 strike price put on a $15 stock. Normally, you'd barely get any premium because the strike price is so far out of the money. But we're getting $2.10 now. That's a 21% yield in three months!

The stock in question is the best company in its sector and owns irreplaceable, trophy assets. It is now trading at 80% of book value and for less than 50% of intrinsic value. For these puts to be exercised (for us to have to buy the stock), the price would have to fall another 33%. And our conversion price (thanks to the rich premium) would be $7.90 – which would be less than half of book value.

The price of this put is simply absurd. The implied volatility was 180 – which means the market is pricing this put as though it's possible for the stock to decline by 180%. While selling puts may not be the best strategy to follow most of the time, right now it is absolutely the best risk-to-return set up in the markets.

Regards,

Porter Stansberry

Baltimore, Maryland

October 17, 2008

Stansberry & Associates Top 10 Open Recommendations

Stansberry & Associates Hall of Fame