How to prepare for a bear market...

How to prepare for a bear market... Think of your portfolio as a train... I don't regret being cautious... How to sleep well at night no matter what the market does next... Another must-read 'Q&A' from Porter...

In today's Friday Digest... how should you handle the risk of a bear market?

Assume for a moment that everything I've been writing about distress in the bond markets continues to get worse and eventually spills over into the equity markets and then into the general economy. If I'm right and we really are on the cusp of a massive wave of credit defaults all around the world, shouldn't you simply sell all of your stocks? Shouldn't you buy lots of put options and short dozens of companies? My answer will surprise you...

Longtime subscribers will remember my first bond-market warnings back in 2013. That May, I explained why the U.S. high-yield bond market had gone completely "nutso" – yields on risky bonds were less than 5%, a rate of income that didn't protect investors from the inevitable default rate for bonds in that category.

In short, investors had bid up risky bonds so high that they no longer offered any real yield. Or as renowned newsletter author Jim Grant cleverly puts it, instead of searching for risk-free yield, investors had begun to buy yield-free risk. I knew it wouldn't last. And I knew that sooner or later, there would be a calamity in that market.

To protect our portfolio, I suggested taking some profits. We sold seven companies – most of which had earned us good returns. On average, the stocks we "locked in" had produced annualized returns of 30% and average total returns of more than 50%. The truth is, you can't expect to make more money than that in stocks.

As you probably know... the markets didn't crash immediately. In fact, the high-yield bond market retested its highs about 12 months later. Stocks, likewise, continued to march higher. And perhaps assuming that we suddenly couldn't read, our subscribers have gently reminded us of this fact – nearly continuously – ever since. Since we sold these stocks, on average, they've gone up 17%. On an annualized basis, they've gone up 8%. By selling, we avoided losses in only two of the stocks (Cheniere Energy and MGM Resorts).

You might not agree with me, but I'm satisfied with our choice. You're never going to sell precisely at the top. And you're never going to buy precisely at the bottom. You should handle your portfolio like an engineer handles a train. Most of the time, stocks go up. As a rule, your portfolio should be mostly "long." You should mainly be a buyer of stocks and bonds.

From time to time, of course, financial assets go down. Sometimes, they go down a lot. When that happens, it's awfully nice if your train is stopped (if you're in cash). It's even better if your train is in reverse (if you're "short" stocks on a net basis). What you shouldn't do, though, is constantly stop and start your train... or even throw it from forward into reverse.

Two years ago, we began to worry about the market. We knew it was due for a correction... or perhaps something worse. We took some money off the table. But we didn't stop buying stocks altogether.

Since then, in my Investment Advisory, we recommended buying Cubist Pharmaceuticals because we knew it was a takeover candidate. We earned a quick, 49% gain when biotech giant Merck (MRK) bought it. We recommended buying beverage distributor National Beverage (FIZZ) because it's the type of business that can thrive during a recession. We've seen total returns of 54% from that recommendation.

My point is, if we had stopped the train altogether, we would have missed out on these opportunities. Worse, if we had tried to put the train in reverse and been 100% short the stock market, we would have gotten killed...

Our short recommendations have been our worst. We've lost money twice trying to short electric-car maker Tesla (TSLA). One of our worst recommendations since 2013 was a 30% loss trying to short customer-relationship-management firm Salesforce (CRM).

On average, our efforts to "hedge" our portfolio with short recommendations and "pairs trades" – where you're long one stock and short another – have resulted in average losses of 3.3%, or 8.3% annualized. These losses have offset our other gains. As a result, we've underperformed the S&P 500 since June 2013. As you can see, timing matters a great deal when you're short.

I don't regret our caution. It's impossible to know exactly when the market is going to roll over. We took reasonable steps to protect our portfolio – to begin to slow the train down. We took our first few "stabs" at shorting the market. Buying insurance doesn't always pay off. But just wait... As the bear market develops, we'll continue to add more short exposure to our portfolio. It was our short recommendations that saved us in 2008. And they will save us again in 2016. When the cycle is finished, all of our shorts will end up being profitable, on average – including the losses we've taken so far.

We invest with humility. We use small position sizes. We use trailing stop losses. We know our timing is unlikely to be right on the mark, so we adjust our portfolio's orientation slowly.

If we had sold everything in June 2013 and gone 100% short, we would have lost a huge amount of money. Instead, we sold some stocks and took some profits. Meanwhile, we let our favorite investments and our best recommendations continue to compound. We've cautiously added "hedges" – short-sale recommendations and pairs trades. We're still waiting for the payoff from those choices, but they haven't cost us much.

Take our example to heart. If you're nervous about stocks and bonds like we are, sell some of your investments. Sell enough so that you can sleep well at night. Sell enough so that you will have plenty of cash if a crash occurs – enough to buy good investments at great prices. But don't feel like you have to sell everything. Don't pretend that you can know exactly when a bear market will begin. Likewise, when you're hedging your portfolio, try adding one or two shorts at a time. If they work, you can add more. If not, you know we're still too early. Remember: Most of the time, stocks go up. That's a hard trend to fight.

New 52-week highs (as of 10/1/15): none.

In the mailbag... Probably the best set of questions and comments we've gotten in a long time. Don't miss the debate/wager between Porter and a Goldman Sachs alum regarding share buybacks. Keep the questions coming and we'll keep answering: feedback@stansberryresearch.com.

"You and the other editors have discussed with us extensively regarding methods to protect ourselves, such as raising cash, trailing stops, position sizing, hedging with gold and taking some short positions. But you haven't touched on buying put options or other tail-risk strategies. Would be interested to hear your comments. Now seems to be a good time to own puts on things like SPY and HYG?" – Paid-up subscriber Justin S.

"You have been warning about the risks of owning HYG since 2013. Why haven't you recommended shorting HYG as a hedge? Is there an underlying characteristic to that position that makes it subject to undue risk?" – Paid-up subscriber Frank D.

Porter comment: In a bear market, you don't have to get "cute." We are entering into the largest debt liquidation cycle in history. The Fed cut the last "cleansing" period short. The coming one would have been a doozy in any case, but the amount of credit creation over the last 10 years has been unprecedented, as I've described ad nauseam over the past few months.

As a result, there will be financial fireworks – huge, massive blow-ups. These blow-ups are going to be bigger and worse than you can imagine right now. This will all happen over the next three years. So by all means... raise some cash. Be careful to avoid low-quality debt instruments. Don't own any junk bonds. Don't own any foreign bonds. Don't own any asset-backed securities.

If you can merely avoid taking losses on these big debt implosions, you'll be way ahead of the game. And you'll be in a position to make a killing, because you will have cash at the bottom when high-quality financial assets will be "on sale" for 50% off (or more).

In short, don't "blow your wad" yet. We're a long, long, long way from the bottom. If this were a baseball game, we wouldn't have even seen the end of the top of the first inning. You want to wait until most people are afraid to turn on CNBC. You want to wait until your friends start refusing to open their 401(k) statements. You want to wait until it becomes rude to talk about stocks or bonds at parties because "everyone" has lost so much money.

So just remember... going to cash is good enough. But if you want to hedge your long positions, I'd recommend shorting companies that own large amounts of low-quality debt. The best firms to target are essentially leveraged piles of bonds, like BlackRock...

I'd also recommend shorting companies that manage and/or deal in foreign bonds, like Franklin Templeton...

You can also target companies whose business models depend on low-cost financing (aka subprime lenders).

In general, I don't recommend buying puts. It's difficult to make money as a buyer of puts. Options premiums are expensive. It's possible to be right about a stock falling and still not make money with an option. Likewise, I wouldn't recommend shorting high-yield bonds directly because it's expensive.

Overall, though, the message you'll continue to hear from me is to simply follow your trailing stops and make sure you continue to raise cash over the next several quarters. Once-in-a-decade opportunities are coming.

"In my business it is helpful to sometimes perform an 'autopsy' on past work. GE has certainly underperformed for a long time and are in the process of an aggressive transformation. I recall some excellent reporting by you during the depths of the Great Recession that focused on the demise of GE (debt, unfunded liabilities). As a former CPA I do appreciate the forensic work that you do. But so far no explosion and instead a methodical sale of assets/divisions etc. I am not interested in GE other than if you think it is a shell game with implosion pending... or is the transformation legit... or what would you say today vs. what your take was back then... the old what would you say then if you knew what you know now." – Paid-up subscriber Jeff C.

Porter comment: The company's recent moves – to get out of finance and to focus on its core industrial business units – is wise. I expect to see its performance improve dramatically. As for why our short recommendation didn't work out, like many overleveraged financial firms, the government saved General Electric. For three years, the U.S. Treasury explicitly guaranteed all of GE's debt. But unlike American International Group (AIG), where essentially the same thing occurred, the government didn't insist on wiping out shareholders. Instead, the guarantees were made without any equity compensation for the government.

Make no mistake about it: GE absolutely would have gone broke without hundreds of billions worth of capital support. It was using the commercial paper market (cheap, short-term loans) to fund $600 billion of the most absurd financial assets you could imagine – everything from subprime credit-card debt to foreign-currency mortgages in Hungary.

The cost of the GE bailout has never been calculated or discussed in the media. Former CEO Jack Welch – the architect of the scheme – should be on a gibbet. If you ever wonder why we never get invited to appear on CNBC, now you know. (GE owned NBC at the time of the crisis and only recently sold it to Comcast.) And if you still think America isn't one of the most corrupt countries in the world, just think about how many prominent politicians depend on CNBC for free advertising – something AIG couldn't offer.

"I like your thesis and analysis of the signs and risks of a looming debt crisis. However, I believe your analyst failed to do his or her homework on one issue. Your table entitled 'Leaders in Value Destruction' should not have included ITW. Their very strong liquidity position mitigates financial risk, as does the long-dated term structure of the debt. In fact, the abundant cash position and buybacks were both funded, not through new debt issuance, but through the divestiture of their less profitable businesses, a fact that is completely at odds with your premise that these companies are all engaged in excessive use of debt-fueled buybacks.

"The facts demonstrate prudent financial management and optimal strategic management. ITW's reinvestment of cash, generated from divestiture or weaker businesses, into the best performing businesses and into company stock, is an elegant way to maximize shareholder value. The proof is in the pudding. ITW will set record profits this year on revenues that are 20-25% below the previous peak. ITW is engaged in sensible, transparent strategic management to improve the quality and consistency of earrings and optimize shareholder value.

"I have seen you (properly) criticize companies that fail to do this. DVN comes to mind. If you have anything to say about ITW, I would expect you to commend their stewardship for shareholders. As for your table 'Leaders in Value Destruction,' you picked on a company that does the opposite... ITW is a leader in value optimization." – Paid-up subscriber Steve K.

Porter comment: Steve, you're correct on almost every point. Illinois Tool Works (ITW) is a good business. It sells sophisticated (and high-margin) equipment to automakers and other industrial segments. It meets our "high-quality business" targets, with impressive operating margins (20%-plus), annual return on assets (10%), and returns on equity (27%). This explains why it consistently outperforms the stock market.

Our criticism of the company's management team, however, was only about how they are managing their balance sheet, not how they operate their company. On that score, I believe our criticism is right on the mark. Let me explain this way...

If ITW were my company – if I owned 100% of the stock and could control how the business managed its balance sheet – I would never carry so much debt (more than $10 billion), nor would I look to buy back massive amounts of stock after a huge move higher in my company's share price.

You complimented ITW's cash position. And at first glance, it looks strong. The company has $4 billion worth of cash in the bank. But this cash is almost matched by $3.5 billion in obligations that are due this year. Thus, its actual real liquidity is only $500 million, which, in my mind, doesn't leave the company with enough in reserves, given its large asset base ($17.6 billion) and its significant debts. Think about it this way... ITW must pay a minimum of $250 million per year in interest on the $10 billion it borrows. Would you want at least three or four years of interest coverage in cash, if this was your business? I would.

You have to remember what business the company is in. There is $2.5 billion in receivables and $1.1 billion in inventory counted as assets on ITW's balance sheet. So more than $3 billion on its balance sheet depends on the health of the auto industry.

Again, if this were my business, I'd want to hold more net cash – at least enough to cover the entire amount of my receivables from the auto industry. I'd be concerned about the financial status of Ford in particular. Ford makes good cars and trucks. I drive a Ford F-250 and I love it. But Ford is a terrible business. It could make more money owning muni bonds than it makes operating its own business. (Its operating margins are less than 3%.)

Ford didn't go bankrupt back in 2008. Instead, it mortgaged its greatest asset – the rights to its brand name. As a result, Ford still has a staggering amount of debt on its balance sheet (more than $120 billion). Given the state of the global auto industry, where overcapacity has eliminated the ability of almost every automaker to establish reasonable profit margins, I'm convinced Ford will never repay these debts. Sooner or later, it will go bankrupt.

If I owned ITW, I would be saving capital to ward against this rainy day. It's sure to arrive in the not-to-distant-future. Therefore, I wouldn't have borrowed another $1.3 billion last year to help finance the purchase of $4.1 billion in my own shares. Especially not when my company's stock is trading at all-time highs and my firm's debt-to-equity ratio is already 150%.

Reading your note may have given other subscribers the idea that all of the funding for the share purchases came from the sale of other corporate assets (an industrial packing unit). But that deal (with the Carlyle Group) only raised $3.2 billion, according to press reports. Why borrow another $1 billion? Isn't a $3 billion buyback enough?

And that was the point of our list. These firms are buying back way too much stock after huge runs higher in their share prices. They're borrowing money to make these buybacks, too. That's not only risky, but I believe it enters the realm of fraud. The intent of these repurchases is to create the illusion of greater earnings power. By lowering the shares outstanding, earnings per share can be greatly increased.

If this were my business, I wouldn't manage my capital structure this way. I don't ever risk money I can't afford to lose in pursuit of money I don't need. ITW already has a great business, with great margins and good returns. There's no reason to leverage this business. There's no reason to strive to make earnings look better by buying back so much stock – especially not at new highs.

The only reason management teams do this kind of stuff is because they're trying to get the stock price up. They want to use the stock's momentum and their inflated earnings numbers to get prices much higher, so they can sell their own shares at absurd prices. So... if I'm right – if ITW's management team has been borrowing money to inflate earnings per share numbers and drive the stock higher – then you'd expect to see the managers selling stock.

And what do we see? Four different senior executives have sold more than $1 million of stock in the last six months. One executive, Scott Santi, has sold more than $7 million of shares. Another, David Perry, sold more than $5 million.

Steve, you aren't an ordinary subscriber. You're a highly successful financial pro and a Goldman Sachs alum. You've been around Wall Street for more than 30 years, and you've done very well. I get a huge kick out of folks like this reading our work and sending us feedback. It's a terrific compliment to our business. As smart as these guys are, though, they don't know everything.

To prove it, I suggest a wager. Steve, if you still disagree that ITW is being poorly managed from a capital structure standpoint – and you don't agree with me that these most recent buybacks will lead to value destruction – here's a proposition: I'll bet you $100,000 that in the next five years, ITW will have the opportunity to buy back stock at a price that's 35% lower than its recent highs, but won't do it.

For me to win this bet, two things have to happen. First, the stock has come under serious pressure (which I believe it will, because its balance sheet isn't as solid as it should be) and second, its management team has to decide not to buy back stock at that time. To be objective, let's say they won't buy back stock within 10% of the future lows.

How can I be so sure? Think back to 2008-2009. The stock traded well below $50 for nearly a year, falling as low as $27. (It's an $80 stock today, and has traded above $90 recently.) Did the managers at ITW buy stock back then? Nope. So if they don't buy the stock when it's cheap... and if they're personally selling this year when the share price is high... why are they using $4 billion of the company's money (and borrowing $1 billion of that) to buy stock this year? There's only one answer. They're crooks.

"You've published your 'coffee can' approach to investing a couple of times. Personally, that's the kind of investor I want to be. I would like to pick some great stocks and then just sit on them, riding them through the good times and the bad. I don't particularly want to bother with trailing stops and with great companies, given I have a long enough time horizon, one would think I shouldn't have to. I really have no desire to be a trader but rather an investor.

"That brings me to my dilemma. My coffee can approach has put my portfolio underwater with picks like Anadarko, EXXI (90%+ loss) and other oil related stocks you recommended in the past. I've lost money on other resource stocks your newsletters have recommended (gold/silver, etc.) Even my holdings recommended by Dr. Eifrig are mostly negative and I consider his picks to be 'forever' type holdings. Apple, Intel, and Microsoft are the main exceptions. Frankly most of my portfolio is underwater, a portfolio consisting of stock holdings based upon recommendations from your newsletters.

"Now I'm hearing we should be heavily tilted toward cash (Porter). I also hear that this bull market still has some legs (Sjuggerud). I'm inclined toward getting cautious and defensive but the only way for me to go to cash in a significant way is to sell my positions. That would mean locking in paper losses and turn them into permanent and real losses. Because this money is retirement money that I won't use for at least 9 years, I'm hesitant to do so telling myself to think long-term – another theme I read about in your newsletters. However, I also know that a 20% loss now is better than a 50% loss tomorrow and having cash to swoop in when the carnage hits is where I want to be.

"Dan Ferris gives some great advice: 'Bottom line: Don't be afraid of the stock market. Be ready to exploit it when everyone else is acting irrationally.' Believe me, I really really want to do this but how? Do I listen to Sjuggerud and Eifrig hoping the bull still has some legs? Or rather do I liquidate, take my lumps now and hope for those super bargains that are going to be waiting for me down the road and make up for the losses I lock in today? Is the coffee can investing story just a feel good anecdote that is not meant to be taken seriously? Is the only successful path to investing being a trader who has to constantly watch his portfolio and sell when triggers hit? How do I reconcile that with when you remind us that Warren Buffett says his ideal holding period for a stock is 'forever'? (Yes, I know he sells positions too.) With 20-20 hindsight, I wish I would have 'cashed out' two months ago. Maybe I still should. Should I try to fill that coffee can with cash?" – Paid-up subscriber Keith B.

Porter comment: Keith, I can't answer questions like yours directly. I can't tell you what to do with your money. That's not because I don't care. It's because of rules the government puts in place to separate guys like me, who write about investing, from guys like your broker, who are supposed to consult with you individually.

What I can tell you is that I've never advocated a "coffee can" approach to investing in stocks. You must have read that somewhere else.

My firm has consistently recommended a diversified portfolio (with no more than 5% of your portfolio in any stock initially) and the use of trailing stop losses. I believe that we've done more to advocate trailing stops than any other investment-research group... and for longer than anyone else. Steve Sjuggerud taught me the concept when I went to work for him back in 1996, and we've never strayed from it.

Of course, there are some exceptions. Extreme Value editor Dan Ferris doesn't generally like trailing stops, because he's recommending deep-value stocks that have liquidation values far in excess of the market price. Dan believes using a trailing stop on these picks is more likely to "lock in" losses, not profits. That said, when we studied Dan's track record carefully a few years ago, we found using trailing stops would have greatly increased the average return on his model portfolio.

Likewise, Stansberry Venture editor Dave Lashmet doesn't use trailing stops because they don't work in the high-risk, volatile stocks he recommends. These stocks routinely rise or fall by 40% and 50% in single trading sessions. The only effective way to limit your risk in these kinds of stocks is by using smaller-than-normal position sizes (1%-2% of your total portfolio). By spreading your bets across a dozen of these ideas, we believe you'll do very well. If you only buy one or two of these stocks... it's likely you'll get wiped out.

I've always used trailing stop losses on the recommendations in my Investment Advisory. The biggest reason for this is emotion. Investors tend to be overconfident – especially during bull markets. But the fact is, it's impossible to know every facet of any given business, much less to understand the every possible dynamic of a large portfolio of stocks. You can't know everything. Using trailing stops forces you to be humble and to admit that you've made a mistake.

Without trailing stops, people tend to practice "buy and fold" investing. "Buy and fold" is what actually happens to almost every investor who sets out to "buy and hold." Sooner or later, the market scares them and they fold, taking huge losses. It seems like this is where you're heading, by the way. If you use trailing stops and reasonable position sizes, this will never happen to you.

Second, trailing stops are the best way I've found to effectively manage risk. If you own a stock that represents 4% of your portfolio and it falls 25% after you buy it, you'll have lost 1% of your portfolio. No major harm done. Sure, you can accomplish the same risk control by never putting more than 1% of your portfolio into any stock, but I believe that approach isn't realistic for most individual investors. Who can effectively manage a portfolio of 50 or 75 stocks by themselves? Nobody I know.

Meanwhile, it's likely that the stock will have ticked up at least a little bit during your holding period. You'll find that using a 25% trailing stop usually limits your actual losses to 10%-15% on average. Getting rid of big losses is the best way to greatly increase your annual portfolio gains.

Most people will never learn how to make money in stocks because they can't escape the urge to make all of their profits with one investment. This leads to big losses – losses that wipe out all of the other gains and more. If you can simply learn to never let that happen, chances are good that you're going to become a much better investor. Just remember: Opportunity is infinite... capital isn't.

Third, trailing stops allow you to lock in gains and raise cash long before the market bottoms. Our resource sector newsletter, the Stansberry Resource Report, had stopped out of every single position by early September 2008. We were completely out of the resource sector before its real nosedive during October. Subscribers who followed our advice had plenty of cash to scoop up gold stocks and other resource firms during the panic that followed over the next several months. By the end of October, one resource investor I know (who didn't sell) said his portfolio looked like "a medieval battlefield at dusk." My portfolio has never looked like that because I use trailing stops. You should do the same.

Finally, while I can't give you any personal advice, it seems that you don't really have a strategy. You're getting advice from a range of sources, but you haven't really settled on which approach you're going to follow. Instead, you're trying to cherry-pick. You're mixing and matching. That's difficult to do unless you're more experienced than the analyst. For example, Dan Ferris has proven he can invest successfully without trailing stops, so you're using that approach. But you're doing so with stocks he has never recommended (and would never recommend). That seems like a recipe for failure.

"You are right: 'There is no teaching, only learning.' In other words, if people are not willing to make the effort to learn, they are burned. I sold out of all my high yield bonds – it took most of the morning – and I researched my bond mutual funds to see how much junk they own. I was surprised by how much some of them had, and thus will be selling those at COB today. Thanks Porter. I KNOW OF NO OTHER BUSINESS THAT DOES SO MUCH, FOR SO MANY, FOR SO LITTLE. As good investors know, protecting against large losses is more important than scoring big gains, because to make up for big losses an investor must earn more just to get back to even, sometimes a lot more." – Paid-up subscriber Rob T.

Porter comment: Thanks for the kind words, Rob. I'm happy to know that our work led you to make a careful evaluation of what you owned. The Fed's low-interest-rate policy has gone on for far, far too long. It's inevitable that in a market environment like this one, fixed-income managers will have purchased all kinds of stuff they shouldn't have. The old saying on Wall Street is "more money has been lost reaching for an extra percentage point of yield than in any other way." The tide is heading out. We're about to learn who isn't wearing pants. Don't let it be you.

Regards,

Porter Stansberry
Baltimore, Maryland
October 2, 2015