These Big, 'Safe' Stocks Could Crash Tomorrow
Editor's note: Chances are good that you own some of what Dan Ferris calls "ticking time bombs."
And at Stansberry Research, one of our primary goals is to keep your portfolio as safe as possible.
In today's Masters Series essay – adapted from the June issue of Extreme Value – Dan explains why he believes a mega-popular group of U.S. stocks is much riskier than folks realize...
These Big, 'Safe' Stocks Could Crash Tomorrow
The vast majority of the time, I recommend ignoring the overall stock market and focusing solely on finding individual stocks to hold for the long term.
But you should pay close attention to the overall stock market in one of two environments: at extreme low valuations (like in late 2002 or early 2009) and at extreme high valuations (like in 1929, 1972, 1987, 2000, 2007, and today).
That's why we've been warning Extreme Value subscribers that U.S. equity prices are manically overvalued since April 2017. We've been cautioning them to hold plenty of cash and to only buy stocks when they have a substantial margin of safety.
Human nature is insidious. Like it or not, investors tend to be most confident when they ought to be most scared... and most scared when it's too late.
On January 26, the S&P 500 closed at a new all-time high. It fell 10% in just nine trading sessions, bottoming out (for now) on February 8.
If you want to know what the world is thinking at any given moment, ask the one source that can answer any question you might have: Google.
Google Trends will show you how popular a search term is relative to overall searches over a given time period. When it hits 100, it's as popular as anything else the world is thinking about. I typed "stock market crash" into Google Trends and set the time frame from January 1 to today. Here's what that looks like...
Google searches hit 100 on February 6, two days before the S&P 500 bottomed out.
This graph represents investor fear of a stock market crash. Crashes are rare events, so it makes sense that investors don't spend much time worrying about them.
But you should worry about swift, large declines in equity prices when stocks are pushing against all-time high valuations. When the S&P 500 peaked on January 26, it also hit its highest-ever price-to-sales ratio of 2.36 times – even higher than its dot-com era peak of 2.25 times. (As we've noted in past issues, economist Dr. John Hussman has demonstrated that price-to-sales is more closely correlated with subsequent 10-year returns than price-to-earnings and other popular measures.)
Nobody was afraid of a market crash when stocks hit their all-time valuation peak. They only panicked and started worrying about a market crash after equity prices had fallen nearly 10%. Fear shouldn't be feared... euphoria should.
Today, euphoria is best represented by the "FANG" stocks – Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google's parent company Alphabet (GOOGL) – which have all recently made new all-time highs. Nobody fears those stocks, which is why they're scary to long-term, value-oriented investors.
But big, "safe" stocks like the FANGs can fall apart just like any other stocks.
In Las Vegas last September, I said that Facebook was vulnerable to a big shock due to its business model (which is essentially the largest surveillance operation in history). The stock fell 21% in less than two months earlier this year over concerns it was misusing users' data, and fell 19% on July 26 after announcing slowing revenue growth and rising expenses.
(I also mentioned Google in Vegas. It was down about 2% in June on the expectation European Union regulators will levy a massive fine for "using its dominant mobile Android operating system to squeeze out rivals," according to the New York Times. The fine is expected to exceed the $2.7 billion fine it paid the EU last year for favoring its products over competitors in search results.)
If Facebook can fall 21% in a few weeks, why couldn't it fall 50% in a few months? Are other mega-cap tech darlings any less immune to big drawdowns? Of course not.
Risk happens fast. You can't afford to start worrying after you've lost a big chunk of money. Learn to fear euphoria and to welcome widespread panic as a potential buying opportunity.
So What Happens When Markets Correct?
In today's stock market, with its (near) all-time high valuations, it's not hard to envision the market falling 50% to correct the current valuation errors it's making. It could fall even farther if you adjust for the extreme fear investors feel when they're liquidating their portfolios at extreme lows. Nothing has to go particularly wrong to justify a massive stock market drop of 50% or more.
Value-investing legend Benjamin Graham recommended looking at the stock market as a manic-depressive partner named "Mr. Market." Mr. Market is willing to buy or sell at any given moment based on his volatile feelings. Investors need to come to work every day prepared to make the opposite assessment of Mr. Market.
When Mr. Market knocks 10% off the value of the S&P 500 in nine trading sessions, he's suddenly less sure that he'll receive those distant cash flows... or that they'll be as large as he once thought they would be... or that 6% a year is sufficient compensation for the risk he's taking. One way or another, he suddenly feels that he has made a mistake, and he wants to correct it quickly.
It's easy to criticize someone for being cautious or bearish too soon, but if equities are priced to lose you 50% or more, is there ever a good time to own them?
Regardless of what you think stocks will do for the next year or two, how certain can you be that Facebook's free cash flow (FCF) will still be growing in 15 to 20 years, let alone at 57% a year like it did from 2013 through 2017? Facebook trades around 29-30 times FCF these days. Good luck holding it if EU regulators decide to make an example of it.
Another wrinkle here is interest rates. Some investors base discount rates on current interest rates. Right now, we're discounting future cash flows at 6% and the benchmark 10-year Treasury bond yields a little less than 3%. What would happen if it were suddenly yielding 4%?
It might not sound like a big difference, but if rates go up 1% and people expect them to go up another 2%, it could spell disaster for stock prices.
With the overall U.S. stock market priced for miserable returns over the next several years, we're in no hurry to load the model portfolio with new long ideas. We'll continue to take a measured, cautious approach to new long ideas, adding only when we find quality companies trading at substantial margins of safety, with limited downside and substantial long-term upside potential.
Good investing,
Dan Ferris
Editor's note: If you're looking for investment ideas with multibagger upside and safe, "sleep well at night" downside, look no further... Dan has found "the kind of stock opportunity you get once or twice in a lifetime, at most." In fact, he predicts it will become the first 20-bagger in Stansberry Research history. Learn more right here.