How to almost always make money during periods of market panic...

How to almost always make money during periods of market panic... The truth behind Bernie Madoff's lies... Why 2016 will see lots of panics... The newest installment from P.J. O'Rourke...

Today's Friday Digest is the first of a five-part series. So prepare yourselves, dear subscribers. I (Porter) will also be writing the next four Digests.

As you might have noticed by now, I'm on a mission.

I believe the "echo bubble" – the massive credit bubble we've seen emerge from the energy sector, student loans, auto loans, and junk bonds of all kinds – is in the process of collapsing. I won't bore you (yet again) with all of the details. It's obvious by now: Default rates are rising, corporate bonds are collapsing, and commodities are getting wiped out.

If you haven't yet, you can read last Friday's Digest, which contains what I think is the best summary of these problems. Or think about what Louis Bacon, one of the world's top five hedge-fund managers, told the Wall Street Journal this morning...

Credit markets are stepping into an unknown world of illiquidity and dysfunction at a time when the world's growth and stretched monetary policy increasingly are dependent on further credit provisioning.

Trust me on this: Next year will be a lot worse.

Credit problems are "contagious." Trouble in credit tends to spread, even into areas of the market that aren't directly distressed. The first big credit fund to collapse, the high-yield Third Avenue Focused Credit Fund, began to "gate" investors yesterday. That means they're trapped. They won't be able to get their money out. Those investors will have to raise liquidity to meet their own obligations in other ways – perhaps by selling bonds that aren't in trouble at all. That's one example of how trouble in high-yield bonds will inevitably spread to investment-grade bonds and the stock market.

And so, I'm on a mission: I want to make sure that every single subscriber knows exactly how to make big gains during periods of market distress.

The big, 1,000-point selloff in August won't be the last market panic we see over the next 12 to 36 months. We will go through at least half a dozen more panics like that... and most of them will be worse. So you have two choices: As you hit trailing stop losses, you can go to cash and try to hedge your remaining portfolio with short-sale positions and some gold. Or you can learn how to take advantage of these moments of panic.

I spent last month teaching you how to use distressed corporate bonds to make big profits. It wasn't easy. I can tell by the mailbag (see below) that a lot of folks still don't understand our strategy or why it works. And in this series of Digests, I'm going to try to teach you something even more complex. I want to show you the best way by far to make money using distressed equities.

Believe me... I know that fewer than one in 10 of you will take the time and make the effort to understand this strategy. That's fine with me. You don't have to learn how to capitalize on equity panics to be a great investor. Like I told you last month, you can live a good life without ever buying a distressed bond. On the other hand, these skills – dealing in distressed debt and distressed equity – are the most lucrative skills I could possibly teach you. And so I have to try. It's what I would expect from you, if our roles were reversed.

Most of what I taught you last month about buying distressed corporate debt was counterintuitive. Learning how to see the markets this way – opposite of the way that most people view them – is critical to dealing effectively in distressed markets.

To prep your brain for this work, I'm going to tell you something about Bernie Madoff that I guarantee nobody else in the press ever dared to write. A very good and obvious reason explains why his Ponzi scheme lasted as long and fooled as many people as it did. This secret says something important about how you ought to invest during periods of financial distress. You're going to love it. But hang on... I'll get to all of that in a minute.

First, I want to give you the big picture.

If you read my series on distressed corporate debt last month, you know why our strategy works: As default rates increase, yields on all bonds soar. But not all bonds default. That makes it possible to earn incredible returns in bonds as long as you can avoid defaults.

Both of our first two bond recommendations are doing well. One is yielding 18% annually, while the other is yielding 25%. We expect to make total returns even larger than these amounts, thanks to the addition of capital gains. It's rich returns like these that more than compensate us for the risks we take when we buy these bonds.

As I've explained, this upcoming five-part Digest series will be about learning to make the same type of gains in stocks. But you need to keep in mind one important difference between investing in distressed bonds and equities. In distressed stocks, rising yields don't create the core opportunity. Instead, rising volatility generates our returns.

During market panics, all stocks see huge share-price swings. Every stock experiences tremendous volatility, but not every stock is actually in trouble. By focusing on the stocks that have the most volatility with the least amount of genuine intrinsic risk, you can generate huge amounts of income and gigantic capital gains, too. That's what I'm going to teach you how to do in these Digests.

As you can see from the chart above, over the last 20 years, the Volatility Index (or "VIX") has rarely gone above 35. It spiked above that level in 1997 (during the Thai baht crisis), 2002 (the tech wreck), 2008 (the financial crisis), and 2011 (the European financial crisis), among a few others. And as you can tell from the table below, huge spikes in volatility normally correlate with a bottom in stock prices...

Distressed Markets Equal Opportunity
Date	VIX	1-Yr. Dow Annualized Return*	3-Yr. Dow Annualized Return*	5-Yr. Dow Annualized Return*
10/30/97	38.2	18.5%	14.7%	4.3%
10/8/98	45.7	40.0%	7.4%	6.5%
9/20/01	43.7	-2.8%	9.4%	9.0%
8/5/02	45.1	15.0%	12.1%	12.9%
11/20/08	80.9	41.2%	19.4%	19.4%
5/20/10	45.8	27.6%	18.2%	15.6%
8/8/11	48.0	25.2%	17.8%	12.4%
Average		23.5%	14.1%	11.4%
* Assuming reinvestment of dividends

These are the most valuable secrets of elite hedge funds and investment banks' proprietary trading desks. Yet I'll show you all of these strategies for free, right here in the next five Digests. All you have to do is read and think. Remember, there's no such thing as teaching, there's only learning. Now, let's go back to Madoff...

Madoff ran the most notorious Ponzi scheme of all time. Over several decades, he managed to steal $60 billion from almost 5,000 people – most of whom were sophisticated and wealthy investors. His biggest groups of clients were charities – all of which had qualified investment advisors.

Madoff's "feeders" (the other investment funds that invested with him) were professional investors who managed hedge funds. Other major investors were private European banks, like Union Bancaire Privée. These institutional investors are not the usual "suckers" who fall for frauds. And over the last 16 years of his fraud, the Securities and Exchange Commission (SEC) investigated – and cleared – his firm eight times!

How could all of these knowledgeable and sophisticated investors (plus the SEC) not realize Madoff was orchestrating a huge fraud? After all, his results should have been correlated to stocks. But even when the S&P 500 dropped 38% in 2008, Madoff's fund was still up 5.6%. That didn't make any sense... or did it?

The most fascinating thing about Madoff wasn't the amount of money he stole. It's who he stole it from and how. Madoff was operating at the center of the world's financial system. He was the chairman of the Nasdaq stock exchange for several years. He was operating from one of the most famous office towers in the world (the "Lipstick Building" in New York). His clients were almost exclusively ultra-wealthy and sophisticated professionals.

Nobody else will tell you this... but the reason Madoff got away with his fraud for so long, and was able to steal that much money, was because the strategy he claimed to be using can, in fact, be incredibly lucrative.

I want to explain what Madoff said he was doing because it's almost the perfect strategy to use in a distressed market. Madoff claimed to generate his results (a little more than 10% every year, no matter what happened in the stock market) by selling call options against a portfolio of stocks, while also buying put options to hedge against downside volatility.

If you've never used options before or don't know anything about them, don't worry. You don't need to know those things right now. I'll explain the details behind this kind of trading later.

All you need to know to understand Madoff's strategy is that there are two kinds of options. Investors buy "put options" if they think stocks are going down or want insurance against downward moves in equity prices. They buy "call options" if they think stocks are going up or if they want to make a leveraged bet – a speculation that stocks are going up.

Madoff explained his results by using phony options-trading tickets. He claimed to sell call options against his investments. Selling "covered calls" generates a moderate amount of income. A covered-call strategy on conservative stocks might generate 10% to 15% a year in total returns. That's how Madoff generated positive returns, at least on paper, during bull markets.

He further claimed that his fund never lost money because he said he financed the purchase of portfolio insurance (put options) with the income he made from selling call options. Sure, Madoff's track record was great because he was making the whole thing up. But it had to be plausible enough to fool a lot of brilliant people, which means his strategy had to at least be possible.

Don't get me wrong, there were plenty of problems that investors and regulators should have caught. The most obvious one was the lie that Madoff consistently told about his track record. He explained that making 10% a year in stocks wasn't a big deal – that it was just a little bit better than the market's average return over the long term. He claimed he wasn't even the best stock-picker in the world. Plenty of investors, he'd say, make more money. It was a clever line. It was true... but it was completely irrelevant.

What made Madoff so famous and attracted so much capital to his firm was that his results never wavered at all. And nothing Madoff said could ever really explain the consistency of his results. As everyone knows, the stock market fluctuates wildly. But not Madoff's fund.

If you want to see something really interesting, go back and read this Barron's article (paywall) on Madoff from 2001. The magazine all but says he must be cheating investors... but it couldn't figure out how he was doing it.

The big red flag in Madoff's explanation of how his strategy worked is that he was claiming he bought puts with the income he made from selling calls. That makes no sense. You see, there's a "skew" in the market for equity options. Put options are almost always more expensive than call options. Why? It's related to human nature...

People fear loss more than they like gains. Put options allow investors to insure against loss – and people are willing to pay up for that protection, especially when they're afraid of what the market and stock prices might do next. Prices for call options, on the other hand, tend to "melt" when the market experiences a lot of volatility. Most investors are too preoccupied with trying to avoid losses to even think about setting themselves up to make gains.

Any experienced or knowledgeable options trader would have told you it's impossible to finance portfolio protection with put options by selling call options. The put options would cost too much. You would lose money every month with this strategy. That's the ultimate irony. Madoff's strategy was backwards, as any experienced options investor could have told you.

In our Stansberry Alpha trading service, we recommend doing the opposite of what Madoff claimed he was doing. We recommend selling put options to finance the purchase of call options. These trades are almost always profitable, because investors can sell put options for more than the call options cost. That allows them to capture healthy amounts of income as soon as they put the trade on.

In other words, by selling puts to finance the purchase of call options, you can make a lot of money even when stocks are flat – just like Madoff claimed he was doing. You will also make a lot of money if stocks go up, thanks to the call options. And, even if stocks go down, you will lose less than the market because you've received some income upfront from every trade. That means you're making money almost all the time by using our strategy.

Over the next four days, I'm going to show you exactly how this strategy works. I'm going to talk about our results from these types of trades in various market conditions. Remember, this strategy works better and better the more volatile the market becomes.

The secret lies in what we call the "Alpha spread" – the difference between the price of a put option (high) and a call option (low) on the same stock. When the market is really volatile, scared investors will pay a lot of money for put options... but they have almost no interest in buying call options. That leads to wide "Alpha" spreads. As I'll show you over the next few days, exploiting this anomaly is an unbeatable way to make money in the stock market.

Here's what you can do on Monday to get ready for this upcoming Digest series. First and foremost, call your broker. (Yes, once again, you will have to use a phone. Sorry about that.) Tell him you're an experienced options trader and ask what his firm requires from you to make Level IV options trades... Explain that you want to be able to sell puts and buy calls to take advantage of market volatility... And ask what the margin requirement will be to do these trades. (That's how much money you'll have to maintain in your account in order to sell puts.)

Every brokerage firm is different. Some firms want this kind of business, some don't. If you don't like the answers you get, call someone else. We'll offer advice on which brokers are best based on the feedback we receive. Just remember: Your broker is there to serve you. Make sure your broker knows you're the boss.

The other thing I'd recommend you do over the weekend is read a few of our older Digests about our Alpha strategy. What I'm hoping you'll soon completely understand is that the whole trick – the real reason this works – is simply because investors are willing to pay so much more for put options than call options.

As volatility ramps up, that dynamic becomes more and more extreme, offering us even better opportunities. So... I hope you will understand this. While other investors are terrified because stocks are going down 5% one day and up 3% the next... you'll just smile knowing that this volatility – the very thing that's terrifying other investors – is enabling us to make huge, safe profits.

You'll see exactly how it works next week.

Meanwhile, if you know you want to learn more about this strategy (the education is free!), be sure to sign up for our live webinar next Thursday night. Just click here to sign up.

One last note... We're excited to be featuring the newest installment from best-selling author and Digest contributor P.J. O'Rourke. Make sure to read what he has to say in today's piece, which is below.

New 52-week highs (as of 12/10/15): McDonald's (MCD) and short position in Santander Consumer USA (SC).

In the mailbag... we're still dealing with subscribers who clearly don't understand our Stansberry's Credit Opportunities newsletter or our distressed-bond strategy in general. Keep in mind, we spent nearly a month straight (five Digests, a two-plus-hour webinar, and a dozen follow-up Digest mailbags) explaining everything in excruciating detail.

It just goes to show that there really is no such thing as teaching. There's only learning. Send your questions to feedback@stansberryresearch.com.

"I took your advice and bought some Cloud Peak Energy [bonds]. Seems like a mistake. Your detailed articles about these bonds stated they were binary, but the ones I bought at Fidelity online, without talking to a soul, seem to be tertiary. I think you meant binary to mean one gets interest and at maturity the payoff for the bond itself, and one can sleep at night since it's so simple assuming no default. Simple enough, but CPE has gone from the 582 I bought it at to today's 550.

"Then I discovered the tertiary element you failed to mention/or I missed it somehow, but I don't think so; the loss of the price is deducted from my holdings in this bond, which doesn't let me sleep as you guys implied. What's this all about? I'm still in and want to get more bonds, but I guess I need to be more cognizant of the potential for the price to fall, or is this some anachronism related to Fidelity that they deny. Fortunately I just dipped my toe in the water as you guys suggested to see how it went..." – Paid-up subscriber Art C.

Porter comment: In the first place, we've never recommended Cloud Peak's bonds. Second, yes, bond prices move. That would explain our actual advice about waiting to buy bonds until they fall into a price range we believe is fundamentally attractive. Again, I can't even imagine how you could have gotten the idea that bond prices don't move if you actually read our materials. I never like to discourage anyone... but I honestly don't think we can help you. It's probably best for you to cancel, get a refund, and let us part as friends.

"Porter, all this talk and text about the next great credit default is very revealing, but you want a person to have $50K available to take part in your investment program. How about something for the little guy with maybe $10-$15K to buy bonds with?? Thanks for your thoughts on this." – Paid-up subscriber Jim B.

Porter comment: You're obviously welcome to subscribe to our newsletter, Jim. We would love your business. But I think it's only fair to tell you that the par price of corporate bonds is generally $1,000 per bond. I believe you should have at least $25,000 to put into bonds, which means a minimum portfolio size between $50,000 and $100,000.

For investors with portfolios like these, spending $5,000 for an entire lifetime of bond research is a bargain. For everyone else, there's really no point in reading it. Please don't blame me... I didn't set the par value of corporate bonds. I don't make the rules. (Oh, and by the way, we offer lots of other research products at very affordable prices – including great free e-letters like DailyWealth.)

"I bought a rental property in Florida as suggested by Steve Sjuggerud. How do you think the upcoming credit crash will affect real estate prices and rents?" – Paid-up subscriber Brian O.

Porter comment: I sold my Miami Beach trophy property last August. Could prices go higher? Of course. And I'm sure they eventually will. But I had already seen prices down there appreciate by almost 100% since I bought in 2011. It seems to me that when there's big trouble in the credit markets, there's likely to be at least a pause in real estate.

Regards,

Porter Stansberry

Baltimore, Maryland

December 11, 2015