'What are we doing?'...

 "Imagine you work for Templeton or Fidelity and your boss comes to you and says, 'We are owning this stock with this guy on the sanctions list? What are we doing?'"

 

Further sanctions against Russia are scaring some institutional investors out of Russian equities, according to the Financial Times. The quote above, from the article, is from an unnamed European fund manager. Another portfolio manager for a U.K. asset-management firm says his fund is "staying clear of any company involved with someone on the sanctions list."

 

 The first set of sanctions from the U.S. targeted Russian officials. The second round was against 20 Russian individuals and big bank Bank Rossiya. The individuals sanctioned were in President Vladimir Putin's inner circle and included businessmen who own large chunks of Russia's biggest companies, like energy company Novatek.

 

 Russia was also suspended (but not expelled) from the G8 – a group consisting of the governments from eight of the world's largest industrialized economies.

 

 Deputy economy minister Andrei Klepach estimates Russia will see $70 billion of outflows in the first quarter, more than for all of 2013.

 

Despite the horrid sentiment, some investors are still nibbling at Russian stocks. They believe the worst is over. S&A Global Contrarian editor Kim Iskyan, recalling his time in Russia during the 1998 financial crisis, says that's a mistake...

 

Back then, the consensus was that Russia was pretty much going to cease to exist...   There was no discussion of buying Russian stocks. People were focused on getting their cash out of the frozen banking system. In the office, people were focused on not tripping over the empty seats belonging to recently fired bankers. I would leave work early to see if there were any "FX deals" at the local wine store – that is, bottles still priced in pre-crash rubles that were now selling for one-third the price.

 

As Kim explained, that's the kind of sentiment you need to set up a 6,500% gain, which is what happened in Russia over the next decade...

 

At the bottom, there were NO articles in the mainstream media from investors saying they're buying Russia... There weren't people saying, "Hey, a cheap market, let's buy!"   That's not to say Russian stocks won't at some point go up by 50% in the coming months. However, what's cheap can, in fact, get cheaper. And just because Russian stocks are trading at a low price-to-earnings (P/E) ratio doesn't mean it can't fall further.

 

Remember... the Russian economy was barely sputtering along – posting gross domestic product growth of 1.3% last year – before all of this controversy started. And Kim believes recession is now practically guaranteed... and it could get worse...

 

Some big domestic borrowers could see margin calls, resulting in forced sales. Some big corporations might have a difficult time rolling over their loans on international markets. And any weakness in the price of oil could further cripple energy-dependent Russia.   Russia's cheap P/E ratio could suddenly look a lot less cheap if earnings decline. I know from experience that sell-side analysts are slow to change their earnings estimates, which then must be uploaded to Bloomberg. So there's a significant lag between things slowing down and forecasts coming down. Also... even before things turned sour, earnings growth was expected to be flat or down slightly.   I'm not saying Russian shares won't rip higher soon. But if/when that happens, it will be a relatively modest swing of the pendulum. In the meantime, cheap can get cheaper... and cheap might not be as cheap as it looks.

 

 Our friend Meb Faber, asset manager for Cambria Investment Management, just published a new book (in Kindle format), titled "Global Value: How to Spot Bubbles, Avoid Market Crashes and Earn Big Returns in the Stock Market."

 

We'll be speaking with Meb about his new book and his findings next week in Digest Premium. If you're not already subscribed to Digest Premium, you can do so by clicking here.

 

 Even if undervalued markets outperform in the coming years, it's still difficult to "hold your nose and buy." And as Kim noted, cheap can always get cheaper.

 

That's a lesson value-investing legend Jeremy Grantham learned in 1999...

 

 Before we get to 1999, we'll share Grantham's views on today's market, as published in a recent interview with Forbes. When asked if he was putting his investors' money into the market today, Grantham, who manages $117 billion, responded "no"...

 

To invest our clients' money on the basis of speculation being driven by the Fed's misguided policies doesn't seem like the best thing to do with our clients' money. We invest our clients' money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns.   The next bust will be unlike any other, because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That's how we will pay for this. It's going to be very painful for investors.

 

Editor's note: In yesterday's Digest Premium, we shared an excerpt from Dr. David "Doc" Eifrig's most recent Retirement Trader update, where he explained a strategy called a "collar trade" – a way to lock in gains on your winning positions, potentially avoid paying taxes, and protect yourself from big moves to the downside. Today, Doc continues his discussion...

 

 

 So using the example of Automatic Data Processing (ADP), we have a stock and two option positions open.

 

We wanted to buy the put because it provides downside protection. If the market does see a big pullback and ADP drops down to less than $65, the put cuts short our losses. Even if ADP goes to $0, we would still be able to sell our shares for $65. We just protected our wealth by buying this put.

 

Rather than pay for that put ourselves, we funded it by selling the call. This way, we didn't have to take money out of our pockets and spend it on "insurance" that we hope to never use.

 

 Again, it's true that if ADP skyrockets, we would miss out on some upside. The owner of the calls we sold would exercise his option to buy our shares for $85 each. But the truth is, with the market acting shaky and ADP already trading at 26.3 times earnings, the likelihood of it making a big jump in the next five months is low.

 

Put another way, without the collar, we have no idea what ADP shares will return for us between now and August. With the collar, we know for certain that our return will be 10.3% at best and -15.5% at the worst. (Again, that's on top of the gains the position is already showing.)

 

It didn't cost us anything. Sometimes, we can even make money when putting the position on. People earn a "net credit" when the price of the call option sold is higher than the put option they buy. In this example, it's exactly equal, neither a credit nor a debit.

 

But remember, the market always falls a lot faster than it rises. That makes put protection more valuable than participating in the upside.

 

Also, if the market stays within the moderate range, we don't have to sell our shares of ADP and pay the capital-gains tax that comes with it.

 

– Doc Eifrig

 

 

Editor's note: You may be wondering why you would use a "collar" instead of simply following (or tightening) your trailing stops. The truth is, Doc thinks we're in the "middle innings" of this bull market, but says that stocks are becoming more volatile. Putting on a collar is one way to help traders sleep well at night. And if you stop out of a position, you're going to have to pay taxes. A collar makes you more likely to stay in the position... thereby avoiding any tax bills.

 

Say you bought a stock in 2009 for $20 a share and it's trading for $70 today. You could raise your trailing stop to $65, or you could set up a collar trade with a $65 put. With a trailing stop, if shares fall to $65, you sell your shares and you'll likely owe around $7-$9 to the government, depending on your tax bracket. You would end up with a gain of around $37 per share ($45 in share price minus $8 or so in taxes).