The S&A Digest: A Trading Strategy Goes Bad

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/28/2013

Ian on trading-strategy black holes... Denver pols take on 'global warming' with new taxes (what a shock!)... H&R Block is upgraded... The Bond King says rates won't rise...

Well... I knew it would happen...

Denver's politicians are getting a jump on the rest of the country. Says the Rocky Mountain News: "Denver Targets Global Warming... The new plan is aimed at making Denver a national leader in reducing gas emissions that have been linked to global warming." (Emphasis added.) The politicians say they'll reduce emissions equal to two coal-fired power plants over the next 12 years. Ha ha ha... How? Oh, dear reader... you know how. They're going to create new "sin" taxes and levy them against people who drive a lot and people who use "excessive" amounts of electricity. Says the mayor, "You can think of them as penalties or you can think of them as market signals. There's some choice involved."

Whether Denver's actions are good or bad for the environment, I can't say. But I do know this: Long after the purpose of these new taxes is forgotten, they will continue to be collected. And, 12 years from now, there will be more power plants along the Front Range, not less.

Ironically, the Rocky Mountain News reports in the same edition that Denver has experienced its latest freeze on record, when temperatures slipped to 31 degrees on June 7. Only twice since records have been kept has Denver seen a frost in June – 1919 and 1951.

General Electric (GE) and Microsoft (MSFT) were considering a joint bid for Dow Jones, but gave up on the idea. Under the deal, GE would have combined Dow Jones with NBC to defend its position against News Corp, which is planning a business channel to rival GE's CNBC.

EU regulators today cleared Extreme Value pick American Real Estate Partners (ACP) for a $2.8 billion takeover of auto-parts maker Lear Corp. Under the terms of the deal, Carl Icahn's ACP will pay $36 a share for the company and assume $2.5 billion in debt.

Investment bank UBS upped Extreme Value pick H&R Block (HRB) from neutral to buy, on a higher chance of a takeover. UBS believes that once H&R Block completes the sale of its mortgage business, it will become a hot candidate for a leveraged buyout (LBO). It's remarkable how so many investment banks will tell the public not to buy a stock when it's cheap... only to urge them to buy it later, at a much higher price.

S&A Oil Report pick ConocoPhillips (COP) will raise its investment in Asia-Pacific by 30% to $1.4 billion this year. The company wants to increase its current 200,000 barrel-per-day output 75% by 2015. CEO James Mulva expects the Asia-Pacific region to be Conoco's No. 1 growth area, consuming one-third of all oil by 2030.

Bond King Bill Gross says the Federal Reserve won't move interest rates until inflation cools. Gross does expect a rate cut due to the housing bust, which is cooling economic growth.

New high: BHP Billiton (BHP).

There's nothing better than a compliment that's delivered after a series of devastating insults. You know the person delivering the praise isn't trying to do you a favor. Maybe that's why we like the mailbag so much – insults tend to be more honest. In any case, we received a blizzard of mail over the weekend... and we faithfully read all of it. Especially the insulting notes... Send us your critique, here: feedback@stansberryresearch.com.

"Porter, I saw you at the Agora conference in Vancouver a few years ago. I took an instant dislike to you. You had this manner. How to put it? Something like I'm the smartest big swinging dick in this room and the rest of you are dumbass wimps. Well testosterone was pouring from every pore. You made quite an impression, to put it mildly. So out of curiosity I started reading your stuff. I understood why you got fragged by your own troops in the paintball battle. I said yes when you bailed from the golf cart as your friend plunged into the drink. And I commiserated with your mom when marveling how she survived raising you up. I wasn't surprised at your pimping term papers in college down Florida way. All this validated my first impression of you.

"Then, sad to say, you continued speaking the truth about company after company. To add to this, your political commentary was consistently on the mark. Then your bevy of newsletter writers seems to represent a kind of gold standard for this genre. I said to myself, Stansberry is such a jerk he couldn't be responsible for all this good stuff. But finally after long hesitation I've had to admit you are about the best out there at what you do. I would have much preferred to have discovered that you were an obnoxious scoundrel. But that is not to be. May your newborn be a copy of you. I'm sure that will make your mom happy and be a sort of poetic justice." – Paid-up subscriber Stan Ragle

Porter comment: When you're extremely passionate about what you do... sometimes it's hard to remember to be nice when you see things going on you know could be greatly improved. But... I'm working on it. (And I rarely go to conferences anymore, which helps.)

"Given the choice between the clear and present dangers of democracies, theocracies, and oligarchies – I'll take the democracies every time." – Paid-up subscriber Evan Clingman

Porter comment: Your choices are strangely constrained. Why not a limited, constitutional Republic? America was never meant to be a democracy; our founding fathers feared mob rule even more than a return to monarchy.

"Are you guys planning on starting a grilling recipe newsletter in the near future? Seems that there is at least as much interest in grilling as there is in stocks here, so why not? If you could include some investments related to barbeques or the cattle industry as well, it could be a wrap. Try calling it True Beef or PSGA (Porter Stansberry's Grilling Advisory)." – Paid-up subscriber DS

Porter comment: Nah... barbecue is just for fun. Man, you shoulda seen the beer can chicken I grilled last night. Oh my...

"You bitch and moan a lot about only having a 14% renewal rate on Dan's newsletter. One would think that you would be jumping up and down with joy. It is obvious that Dan has done an excellent job, and his numbers show that! What you seem to be missing is that 86% of his former readers have been able to act on his recommendations, and be properly placed in their holdings for the next 10 years. Unless they need some boring material to fall asleep with at night, why renew? In 10 years they will come back to rebalance their holdings, or gloat over the gains." – Paid-up subscriber Larry

Porter comment: Larry... that's an awfully good point... And we'd be satisfied if 100% of our subscribers bought Extreme Value once every 10 years.

"I understand your position on newsletters and the idea of getting someone's interest in them by giving a limited amount of information so that they will subscribe to that publication. What I have a problem with though, is that I am subscriber to True Wealth and the other day while reading the S&A Digest there was an article by Steve Sjuggerud. I was interested since I am one of his subscribers, but when I got to where the information on the particular stock was about to be revealed. (GOTCHA) Please subscribe to Sjuggerud Confidential for $2,000. This was a slap in the face and I will cancel my subscription to True Wealth." – Paid-up subscriber Ken Adams

Porter comment: Ken... I'm sorry to see you go. As you know, True Wealth is an excellent newsletter and a great bargain. But Steve writes more than one newsletter. As we've explained, Sjuggerud Confidential covers smaller stocks that are typically a bit more risky than Steve's True Wealth recommendations. To effectively cover smaller stocks, you have to write to a smaller number of people. Thus, from a business standpoint, we have to charge a higher price. (By the way... just because we charge more for Sjuggerud Confidential doesn't, necessarily, mean it's a "better" newsletter. It simply covers opportunities that are smaller, riskier, and have potentially more upside.)

"You are so correct about working for people you admire. Thirty-two years at ALLSTATE was my fate. The first eighteen I worked for people I liked and admired, the last fourteen where for self serving, arrogant, dishonest people I could not and would not get along with. I was miserable! Now that I am retired, my loyalty has been repaid by my cancelled homeowners policy in FLORIDA. Is this a great company or what?" – Paid-up subscriber Bob R.

Porter comment: Sounds like you should have left after the first 18 years...

"O.K., you seem desperate for some unfavorable comments, so here you go. I have been mildly irritated since you started publishing the Digest when you make remarks about different stock picks that your editors have written about in the past. Just because they are 'old news' and some of them are no longer buys doesn't mean I and other subscribers may not be watching them for an opportunity to buy them. We don't all have infinite resources to buy everything that is recommended at the time that you recommend it, and we may intend to purchase a stake in the future, so more discretion with the information that we pay for would be appreciated." – Paid-up subscriber Gary S.

Porter comment: You can't please everyone... Folks who have invested in the picks certainly appreciate it.

"I know it is not the same at this time, but I first subscribed to PSIA when it was identified as Pirate Investors, and there was only one letter – not the library they have now. And I made a killing on JDSU. I was 22 at that time. They call me JUICE." – Paid-up subscriber JUICE

"Munger says you should not be extreme – he likes a moderately faithful wife, moderately honest associates, moderately loyal friends – just because someone makes $ is no guarantee he has wisdom in any other area. Remember the Goldwater quote on extremism?" – Anonymous

Porter comment: You know... if you try to misinterpret something hard enough, even the golden rule can sound like a bad idea.

"Actually I am more than sick of your repeated selling attempts via ad nauseam e-mails. That is NOT why I sent you money... Most of all, you had the audacity to advise on BUD, AFTER the pathetically unreliable and DISHONEST NY Post story. The NY Post? Excuse me while I lose my lunch! How about coming up with an original winner? Everyone has this BUD story. It's OLD!!!!!!! Exactly what good are you? Can I get my money back? You are useless!! And very irritating!!!!!!" – Paid-up subscriber Gary Gruen

Porter comment: Actually, we recommended BUD more than a year ago... probably 16 months before the NY Post article.

"Rob described AHP, currently Wyeth, as American Health Products a number of times. Wyeth used to be a division of American Home Products and then they decided to use the Wyeth name for the whole business. But I don't believe it was ever named American Health Products." – Paid-up subscriber Bill McKeen

Porter comment: Very keen observation, Mr. McKeen. You are correct. We regret the error.

"I am a subscriber to Graham Summers' Inside Strategist and yet, you tell me that Bill Bonner (founder of Agora) doesn't even bother to read it; that he only reads one of the newsletters (Extreme Value) that his company publishes. That might be a big boost for Dan Ferris, but that's not exactly a ringing endorsement for my selection or any of your other newsletters. Did you ever happen to ask Mr. Bonner why he doesn't read any of the others?" – Paid-up subscriber Lawrence Daggi

Porter comment: Bill is an extraordinarily contrarian investor. He's only interested in stocks that no one – not even the company's insiders – want to buy. Besides... his global holding company (Agora Inc.) probably publishes more than 100 books, magazines, newsletters, and e-zines each month. It's not feasible for him to read all, or even very many, of the publications he owns.

Regards,

Porter Stansberry

Baltimore, Maryland

A Trading Strategy Goes Bad

By Ian Davis

A highly successful trading strategy can go from a gold mine to an empty hole in the ground faster than you can imagine.

One of the first trading strategies I developed returned 1,030.4% between 1988 and 1994, an annualized gain of over 48%. However, after 1994, the strategy stopped working. Between 1994 and 2006, the same strategy returned only 12.6%, an annualized gain of only 1%.

The trading strategy was a hedge-fund-style strategy that went long the best-performing MSCI global indexes and shorted the worst-performing indexes.

So why did this strategy stop working?

Well, the cause was probably two-part:

1) The enormous growth in the popularity of hedge funds. Hedge funds have often sought out long-short strategies as well as international investments. When a large number of hedge funds all start throwing their money at the same strategy, it is just a matter of time before the free money is arbitraged away.

2) The development of a global marketplace. The economies of the world are becoming more and more intertwined. When you are placing a trade long and a trade short in two countries that are highly correlated, you're basically playing both sides of the same trade. Your returns are inevitably going to be close to zero. The higher the correlation between two foreign countries, the less profitable this trade becomes.

Why This Won't Happen with Max Value

Max Value, which I've been developing in my weekly newsletter, Quant Trader, neatly sidesteps the hedge-fund pitfall. For one, it is a long-only strategy. We simply bet on a sector or country that is the most out-of-favor and in an uptrend.

The difference between out-of-favor and in-favor stocks becomes smaller or larger as the correlation between indexes changes. In other words, if every index climbs or falls more or less in lockstep with the others, there's not much to distinguish between a favored index and one that's beaten-down.

As correlation increases, the long-short strategy returns close to 0%. But if there ever came a time when all of the indexes were 100% correlated, Max Value would simply produce returns in line with the overall market.

Like any trading strategy, if enough money is thrown at it, its performance will suffer. However, I developed the Max Value strategy to maximize long-term returns. Very few hedge funds or mutual funds are focusing on their 10-year return, since they have to justify their holdings every quarter. Also, since we're trading sectors that are out-of-favor with investors, money managers would have a hard time justifying their holdings to their investors.

Conclusion

It's still early in the game, but so far, our Max Value strategy is off to a strong start. All our Max Value trades – which include plays on pharmaceuticals, recreation, and training and employment – are in the black. And we're up 12.2% and 1.8% on our most recent trades, which we placed last month.

In today's market, as global indexes become more correlated – and everyone is trying to make a quick buck – strategies, like Max Value, that focus on long-term returns and avoid playing both sides of the market, are the most likely to perform well going into the future.

Good investing,

Ian Davis

June 11, 2007

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