by Louis Basenese, Small Cap and Special Situations Expert
Thursday, August 19, 2010: Issue #1327

Second quarter earnings season is officially over – and almost 80% of the companies in the S&P 500 beat their earnings expectations.

You’d think that would be enough to propel the markets higher. But not so fast.

Investors remain confused. Forget solid corporate profit growth. They don’t know what to make of persistent European debt woes, a floundering real estate market, looming tax hikes, or stubbornly high unemployment.

In short, they’re more uncertain about the future than Brett Favre. And as you know, the stock market hates uncertainty…

That uncertainty and confusion is manifesting itself in the form of increased market volatility.

But what’s happening beneath the surface is more consequential and potentially profitable…

The Precarious Plight of Too Much Cash

Is there such a thing as too much cash?

In this case, yes.

• According to Moody’s, U.S. non-financial companies are sitting on $1.84 trillion in cash. As a percentage of total assets, that represents the highest amount in over half a century.
• Hedge funds are holding 24% of their assets in cash (or roughly $450 million).
• American households have just under $1 trillion parked in money-market funds, according to the Investment Company Institute.

I’m sorry… but with cash yielding next to nothing, such passivity cannot persist. Eventually, people need to put the money to work.

Or as Credit Suisse recently opined in a 200-page “brief” on the markets: “Cash in a difficult time is like blubber on a seal: protecting the animal during the harshness of winter, but turning bothersome in spring and summer.”

With the worst of the recession behind us, we’re definitely entering the extremely “bothersome” period. And the situation is the most bothersome for hedge fund managers…

These Guys Need to Start Spending Like Sailors on Shore Leave

If these guys don’t put their cash to work and try to earn a profit on it, investors will say “sayonara” and withdraw their funds. After all, you don’t pay a hedge fund manager a 2% management fee and a 20% performance fee to act like a certificate of deposit.

And since half of the 2,000 funds tracked by Hedge Fund Research’s composite index are still below their high-water mark, these managers won’t get to collect that juicy 20% performance fee if they don’t deliver serious profits.

And there’s just no way they can hit a new high-water mark with 24% of their assets in cash-based investments. In addition, I can assure you that hedge fund managers won’t be content earning a 2% management fee indefinitely.

The good news is this: as they inevitably put their cash to work, we can profit from it…

It’s Time to Start Tracking 13-D Filings

I expect the most aggressive hedge fund managers to put their cash to work and become “activists.”

By that, I mean they’ll take a 5% (or more) stake in specific companies and start demanding aggressive changes. This includes things like seats on the Board of Directors… ditching the company’s top brass… the payment of special one-time dividends… or even the outright sale of the company.

In other words, they’ll do anything and everything to unlock value, stat!

Research proves that it’s an effective strategy, too. The latest academic studies, including the most recent one from New York University, finds that stocks targeted by activists enjoy an average 18% gain.

So how do we profit from these activist situations? Simple…

We follow the lead of the most aggressive hedge fund managers. You see, the SEC requires these guys to disclose when they take a 5% (or more) stake in publicly traded companies within 10 days.

And they do so by filing a form 13-D, which you can easily track for free on the SEC’s website.

But I prefer to visit Barron’s website. Every week, it provides a quick rundown on the latest filings, including a brief summary of the details surrounding each company.

You need to be a Barron’s subscriber to get this information, but as far as I’m concerned, it’s a worthwhile investment if you want to uncover stocks with the potential to return 18% (or more). Especially since the S&P 500 is down 1% this year.

Bottom Line: Executives, hedge funds and everyday investors – almost the entire investment and corporate community – are gun shy. They’re all stockpiling cash and if you’re not tracking the moves of the most aggressive hedge fund managers already, you need to be. It’s an easy way to determine when all the cash on the sidelines is being put back to work – and how to profit from the moves. So don’t delay.

Good investing,

Louis Basenese

by Louis Basenese, Small Cap and Special Situations Expert
Thursday, July 22, 2010: Issue #1307

The dreaded double-dip recession chatter is getting louder by the minute. And it’s clearly scaring the dickens out of most Americans.

How else do you interpret the five-fold increase in the number of Google searches for “double-dip recession” since May?

My advice? Get some earplugs. Seriously.

I’ll concede that the wounds from the Great Recession might still be raw. And given the impact of the crash on investment portfolios, many retirement plans might still be on pause.

But as demoralizing as the thought of another downturn is, the chances of a double-dip actually happening are slim. And it’s certainly not worth losing any sleep over.

Here are four reasons why…

Do You Believe in Double-Dip Recessions and Unicorns?

The first reason not to worry about a double-dip recession is simple. They’re rare. Extremely rare.

In fact, the National Bureau of Economic Research says that over the past 80 years, we’ve only endured one of them – from 1980 to 1982.

And over the past 150 years, we’ve only encountered… (wait for it)… three.

Translation: We have a better chance of seeing a unicorn before another double-dip recession. Well, almost.

If you’re looking for a little more meat on the bone, look no further than my second reason…

Double-Dip Defiance From Corporate America

If America were heading into a double-dip recession, we’d see the downturn reflected on corporate balance sheets across the country.

But that’s not happening. Quite the opposite, actually…

Corporate profits are rising – up 52% during the first quarter, with analysts forecasting a 34% increase once the second-quarter results are tallied.

And that’s not the only positive trend. Consumer spending, capacity utilization, industrial production, retail sales and the average number of hours worked are all rebounding, too.

In fact, of the 40 economic indicators that I track, the overwhelming majority have steadily improved over the past year.

I’m not the only one who believes the current economic data flies in the face of the double-dip recession talk, either. Credentialed economist and Lord Abbett’s market strategist Milton Ezrati offers seven reasons why you shouldn’t fear a double-dip in a recent Wall Street Journal blog post.

Now I’ll readily concede that the momentum of the economic recovery might have slowed over the past couple of months. But that’s not fazing these guys…

These Two Heavyweights Are on the Same Page

Former Federal Reserve Chairman Alan Greenspan notes that the current environment seems to resemble the typical pause patterns witnessed during previous recoveries. In other words, the recovery is still intact.

Don’t trust Greenspan’s assessment? No worries. Consider Warren Buffett’s…

In his 2008 “Letter to Shareholders,” he wrote of “life-threatening problems,” “non-functional” credit markets, “tumbling home prices” and “a freefall in economic activity… that I have never before witnessed.”

Financial Armageddon, you might say.

But nowadays he’s preaching a different story, saying: “There’s no doubt in my mind, we’re coming back.” And he offers irrefutable proof: Most of the 70 companies in which Berkshire Hathaway owns a stake are improving their margins and hiring workers again.

And then there’s the Federal Reserve…

This Indicator Says There’s Zero Chance of a Double-Dip Recession, Too…

What’s one of the best indicators that the Fed uses to determine the probability of a recession?

It’s the Treasury spread – i.e. the difference in yields between 90-day Treasury bills and 10-year Treasury bonds.

The calculation allows the Fed to construct a yield curve.

As the New York Fed reveals: “Research beginning in the late 1980s documents the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity.”

So how do you read the yield curve? Simple…

• Steep Yield Curve: Points to economic growth.
• Flat or Inverted Curve: Signals an economic slowdown or recession.

And as the latest Treasury Spread Model shows, there’s a 0.19% probability of a recession in the next year. Take a look… and relax.

What can we conclude from this? That there’s essentially no chance of a double-dip recession in the year ahead.

The fact that previous spikes in the indicator accurately predicted other recessions (denoted by the gray bars) should only increase your confidence in this indicator, too.

Bottom line: While the economic picture isn’t all rosy (unemployment remains uncomfortably high and credit remains tight), we’re certainly not facing the dire fundamentals of two years ago. And too many economic readings are improving for a double-dip recession to be in the cards.

And that’s before we even get to one final – and the most important – reason not to fear a double-dip recession…

It’s NOT the Economy, Stupid!

Simply put, it doesn’t matter!

No matter what happens, it’s still possible to invest safely and profitably – even if you’re the most risk-averse investor.

All you have to do is focus on this strategy…

• Pinpoint simple businesses, selling recession-resistant products or services.
• Look for companies that have a minimal need for credit and are churning out gobs of cash.
• Identify stocks that pay a modest, safe and increasing dividend. After all, countless studies show that almost half the gains in the S&P 500 since 1925 can be attributed to reinvested dividends.

Basically, look for companies that will thrive in any environment.

Now here’s the good news: You don’t have to look very far to find such investments…

The Ultimate Retirement Portfolio

At The Oxford Club we dedicate an entire portfolio to sleuthing out such opportunities and we call it The Ultimate Retirement Portfolio.

And our strategy doesn’t just look good on paper, either. It works.

Consider this…

• None of the 15 companies in our portfolio suffered a debilitating blow to demand during the Great Recession. In fact, sales at all but three companies actually increased – by an average of 13% – right through the recession. And the three laggards only suffered modest declines of 5% to 8%.
• Every single company maintained its dividend. And 10 out of 11 were able to increase their dividends in 2008 and 2009.
• We’ve only experienced one loss (a modest one of 7%) since we created the portfolio.

Such stats don’t happen by accident. They’re a result of steady demand and conservative financial management. And there’s never a bad time to buy such companies – including now.

I encourage you to sign up for risk-free trial today so you can find out the identity of these 15 all-weather, ultra-safe, high-yielding stocks (plus new ones as we recommend them).

Or you can let fear get the best of you and miss out on the opportunities altogether. You decide.

Good investing,

Louis Basenese

by Louis Basenese, Small Cap and Special Situations Expert
Wednesday, July 14, 2010: Issue #1301

Don’t look now, but biotech darling Dendreon Corp. (Nasdaq: DNDN) is sucking wind.

The stock had surged 119% this year on the prospect of receiving FDA approval for its novel prostate cancer treatment, Provenge. But since having that news confirmed on April 29, its shares have slumped by 44%.

What gives?

Well, you can’t blame the poor performance entirely on the market. The average biotech stock, represented by the iShares Nasdaq Biotechnology ETF (NYSE: IBB), is only down 16%.

Instead, the company has become a victim of its own success.

Provenge Demand Is Surging… But Supply Can’t Match It

The good news for Dendreon is that demand for Provenge is outstripping supply. But the bad news is that Dendreon can only make enough of the drug to treat about 2% of eligible patients until its manufacturing ramps up in mid-2011.

To put the shortage in perspective, consider The University of Texas MD Anderson Cancer Center. The center sees 40 new prostate cancer patients each week… but it will only be able to treat two new patients a month with Provenge.

As ethics expert Jeffrey Peppercorn put it, “In oncology, we’re not used to situations where we have a treatment that may help and we don’t have enough of it.”

Unfortunately, the problems weighing on Dendreon’s shares don’t stop there. And if you’re itching to gain exposure to the immunotherapy space, you’d be better served considering a micro-cap company I’ve mentioned here before – Northwest Biotherapeutics, Inc. (OTC BB: NWBO.OB). Here’s why…

Provenge vs. DCVax®-Prostate

When I first profiled Northwest, I confessed that it was an early opportunity. In fact, I even indicated that Wall Street was “completely oblivious to the company’s existence.”

But I predicted that its anonymity wouldn’t last long. Not when it was putting up such compelling, also highlighting its compelling clinical data.

When I discussed Northwest’s progress in November 2009, I noted that the median survival rate for patients receiving Northwest’s DCVax®-Prostate treatment checked in at 38.7 months. That’s almost a full 20 months better than the median survival rate for standard prostate cancer care.

In early June, Dr. Navid Malik of the London-based Matrix Corporate Capital released a bullish 40-page report on Northwest, also highlighting its compelling clinical data.

As Malik reveals, “Dendreon’s Provenge was approved based on a median survival of 25.8 months from the IMPACT trial (D9902B), compared with 38.7 months with DCVax®-Prostate.”

Let me share Malik’s other key points, particularly his comparisons with Dendreon…

• In terms of manufacturing, which seems to be Dendreon’s Achilles heel out of the gates, Northwest appears to hold an advantage: “Its unique batch-manufacturing process allows it to produce, in a single manufacturing run, at least three years of treatments.” In comparison, Dendreon’s manufacturing process produces only one month of treatments (and Dendreon considers that one month to be a full course of treatments for a patient).
• Malik’s report also highlights Northwest’s greater product purity – 80% dendritic cells, compared to Dendreon’s 15% dendritic and other antigen-presenting products.
• Northwest’s DCVax®-Prostate is also easier to administer – intra-dermal (like a flu shot), versus a one-hour intravenous infusion for Provenge.

When it comes to cancer treatments, results take precedence. Because Northwest still needs to complete a Phase III study, I can’t say definitely that DCVax®-Prostate is superior to Provenge. But what I can say is that based on the preliminary results, and the other items noted above, the comparison is promising, indeed.

I’m convinced Northwest’s biggest competitive advantage, though, is cost…

Healthcare Reform Endgame: The Year of Your Life Has a Price

One consequence of the newly minted healthcare reform is that insurance companies are now extremely sensitive to costs, particularly for cancer treatments. So much so that a year of your life could be given a specific (and decreasing) value.

I say that because President Obama, via a recess appointment, just installed Dr. Donald Berwick at the helm of the Center for Medicare and Medicaid Services (CMS).

The move makes the threat of rationing very real – that is, the government deciding what treatments will be available, instead of patients and doctors.

Case in point: In an interview last year, Berwick said, “The decision is not whether we will ration care. The decision is whether we will ration with our eyes open.”

Berwick looks to the United Kingdom’s National Institute for Health and Clinical Excellence (NICE) – and its calculation of cost per quality-adjusted life-year – as a model. At present, NICE puts the value of a year of life at around $45,000.

So how does that impact Provenge and DCVax®-Prostate?

If There’s a Price on Life, Northwest May Boast Better Quality for the Money

By this metric, Dendreon’s Provenge fails. The price tag for three infusions is $93,000. That’s equivalent to a one-month treatment regimen, which only delivers a four-month benefit in median survival.

In comparison, Northwest can provide almost three years worth of treatments for nearly the same cost. (Malik estimates DCVax®-Prostate will cost $37,000 per year). And its median survival benefit, based on Phase I/II data, is almost 20 months.

Given the lower price and longer benefit, it’s conceivable that DCVax®-Prostate could become a front-line therapy… if approved.

In short, that means greater profit potential, as higher volumes will more than offset the lower margins. And ultimately, the margins on DCVax®-Prostate may not even end up being lower. Northwest’s unique batch-manufacturing process already keeps costs manageable and the company has also developed partial automation which can lower the costs even further.

As for Provenge, the high cost has already prompted the CMS to initiate a National Coverage Analysis. The potential for a negative outcome is the second major reason why investors have shunned Dendreon shares recently.

More Than a One-Trick Pony

To be clear, Northwest remains a speculative investment.

However, it’s important to note that its success doesn’t hinge on a single immunotherapy treatment – DCVax®-Prostate, nor on one-upping Dendreon.

On the contrary, Northwest boasts a pipeline of immunotherapies for the treatment of brain, lung, ovarian, liver, head & neck and pancreas cancers.

The most advanced candidate is DCVax®-Brain. The median survival time for patients receiving the treatment in Phase I and Phase I/II trials checked in at 36.4 months. That’s more than double the standard of care (surgery, plus radiation and chemotherapy) of 14.6 months.

As Malik concludes, “If DCVax®-Brain and DCVax ®-Prostate are successful in their respective late stage trials and eventually approved, we see the potential for blockbuster sales for both products.”

One obstacle in the company’s way is financing. To be fair, though, that’s a concern for any biotech company.

In this regard, it’s worth noting that management is taking steps to restructure its balance sheet. The fact that the company continues to raise capital – $2.65 million in the second quarter – is a positive, too, as it demonstrates that other investors recognize the investment potential here.

No Déjà-Vu for Dendreon

In the end, there’s very little chance that Dendreon’s stock will deliver a repeat performance.

Forget the manufacturing capacity and treatment cost issues weighing on the shares. Even if they’re resolved, matching the 474% rise that shares enjoyed in 2009 would entail the company’s market cap jumping from the current $4.4 billion to about $20 billion.

And with virtually no revenues, even the most aggressive analysts would have a hard time justifying such a lofty valuation.

On the other hand, Northwest is still small (its market cap is just $50 million. Plus, it’s relatively undiscovered and still has significant milestones to meet, which will serve as future stock price catalysts.

Conclusion: Although Northwest is a more speculative investment, more upside remains – and considerably more, based on Malik’s estimates. He puts a target price of $4.40 on the stock in his report – 528% higher than the current price.

I’ll concede that’s a bit aggressive in the short term. However, it’s perfectly conceivable that shares could pop by 155% and reclaim their 52-week high on the announcement of a partnership deal, a rumor that has circled in recent weeks.

At the very least, think twice before you invest in Dendreon. And keep on eye Northwest.

Good investing,

Lou Basenese

Editor’s Note: History has shown time and again that the most explosive stock market returns come when you invest in small, under-the-radar companies that Wall Street and the mainstream crowd know nothing about. And when these stocks hit the big time, that’s when savvy, early investors clean up.

Louis Basenese is a master at unearthing these thriving companies in his White Cap Report investment advisory. Companies with unique, critical products and often with a serious competitive advantage, too. Check out this report to see what innovative companies Lou and the team is looking at right now.

by Louis Basenese, Small Cap and Special Situations Expert
Thursday, July 1, 2010: Issue #1293

You see that ugly 268-point Dow sell off on Tuesday, followed by the 96-point drop yesterday?

Whatever you do, don’t panic and run for cover in triple-leveraged inverse ETFs.

They may promise big returns, should the market really falter. But I’m here to tell you that they’ll do anything but.

You see, triple-leveraged ETFs (whether long or short) pack a nasty surprise. It’s almost unbelievable, actually. And in this volatile market, they’re hardwired for losses.

Here’s what I mean…

The Nuts and Bolts of Leveraged ETFs

Leveraged ETFs have been around about as long as Hannah Montana (only since 2006).

Given such newness, let’s first make sure we’re all on the same page about the general mechanics of how they work…

• Exchange-traded funds are constructed to mirror the movement of some underlying index. If the index rises 5%, the ETF tracking it is supposed to rise 5% (before expenses).
• An inverse ETF simply moves in the opposite direction of the index it’s tracking. So if the index drops 5%, the inverse ETF should rise 5%.
• Apply leverage, however, and the movements are magnified. So if the ETF uses three-times leverage and the index falls 5%, the ETF should rise 15%.

Sounds simple enough in theory, right?

Too bad the reality doesn’t measure up.

Leverage? What Leverage?

Exhibit A: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9%.

• A long ETF using three-times leverage should have dropped by 17.7% (minus 5.9 multiplied by 3 = minus 17.7%). But it didn’t. It plummeted by 65.6%.
• An inverse ETF using three-times leverage should have been up 17.7%. But it sank by 83.4%.

Talk about not getting what you paid for.

Pick any other period and I promise it will yield similarly confounding results. And the worst offenders will always be the ETFs using three-times leverage.

The question is: Why?

Two Fatal Flaws of Leveraged ETFs

To be clear, I don’t detest all ETFs.

Their advantages include…

• A low-cost way to achieve instant diversification and/or access markets otherwise not readily available.
• Unlike traditional mutual funds, they also provide intraday liquidity.

But when it comes to leveraged ETFs, those benefits are completely nullified by two fatal flaws in the set up…

• Daily Rebalancing: Leveraged ETFs don’t actually buy individual stocks. Instead, they invest in derivatives. And these derivatives require daily rebalancing in order to match the rise or fall in the index. Otherwise, the leverage ratio for the ETF will be off-kilter. As a result, leveraged ETFs can only be counted on to perform as promised for a single day.
• Compounding Hurts: For years, we’ve been wooed by the power of compounding returns. If you’re 18 years old and invest $2,000 per year for three years (and not a penny more after that), they say you’ll end up a millionaire if you simply leave it invested and let compounding work its magic.

But when it comes to leveraged ETFs, compounding often works against us.

Consider an index that drops by 10% on Day 1, then rises by 10% on Day 2.

If you started with $100, the index would be at $90 after Day 1 and $99 after Day 2. Total return: minus 1%.

Now let’s take a look at what happens with an ETF that seeks double the return of the index – i.e. uses two-times leverage. Again, we’ll assume a starting value of $100…

• Day 1: The ETF would be down 20% to $80.
• Day 2: The value of the ETF would rise by 20% to reach an ending value of $96.
• Total return: minus 4% when it should actually only be down by 2%.

If we ratchet up the leverage to three times and extend the holding period, it magnifies the negative impact of compounding. Toss in some market volatility and this tracking gets even worse.

Stocks Are Down… But Don’t Try to Take Advantage With These Leveraged ETFs

In case you didn’t notice, volatility is back. The average daily change of the S&P 500 is above 1% – roughly double the historical average.

So ignore the headlines pegging leveraged ETFs as “the ultimate hedge for individual investors.” The truth is, there’s never been a worse time to own them, particularly the 40 triple-leveraged ETFs currently available.

You see, beneath a simple exterior – and the allure of a novel hedging strategy – there are considerable complexities and risks. And unless you think you can predict each of the market’s upward and downward moves every day, you’ll never get what you bargained for with leveraged ETFs. Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive.

I recommend you avoid triple-leveraged ETFs at all costs.

Good investing,

Louis Basenese

P.S. Don’t forget to follow me on Twitter. It’s the only way to get my latest insights, market musings and a glimpse of the research I’m reading as each trading day unfolds.

From time to time, I’ll also highlight stocks I find extremely compelling, like I did yesterday when shares of a leading alternative asset manager dipped below $10.

To find out the ticker all you need to do is follow me on Twitter and review my recent tweets:

P.P.S. For a full list of the ETFs that I referred to in this article, just visit this link: http://etf.stock-encyclopedia.com/category/triple-leveraged-etfs.html. You’ll note that the list is actually comprised of 42 ETFs, but you need to exclude the two from Barclays, as they’re Exchange-Traded Notes (ETNs) not Exchange-Traded Funds (ETFs).

by Louis Basenese, Small Cap and Special Situations Expert
Friday, June 25, 2010: Issue #1289

Following this week’s record low reading for new home sales, you might think now is the worst time to bet on a housing recovery.

Think again.

The aftermath of such disappointing news represents an ideal contrarian opportunity. And I’m convinced that now is the perfect time to bet on a real estate recovery – at the housing market’s “ground zero,” no less. Yes, I’m talking about in Florida and Arizona.

Now, before you think I’m crazy, consider this: Even the late, great value investor Benjamin Graham would agree. Here’s the deal…

Avatar Holdings: A Profitable Formula That Involves No Guesswork

If you’re looking for me to tell you precisely when a rebound in real estate prices will materialize, I unfortunately don’t have a crystal ball.

However, I do own a pocket calculator and it reveals an extreme disconnect between the market price and the liquidation value for Avatar Holdings (Nasdaq: AVTR) – a developer of active adult and primary residential communities, with over 16,000 acres in Florida and Arizona.

The formula I’m using to make the determination here is one with a storied and irrefutable track record – Ben Graham’s Net Current Asset Value (NCAV) per share.

Net Current Asset Value (NCAV) The NCAV formula is as simple as you can get. You simply subtract a company’s total liabilities from its current assets. Then divide by the number of shares outstanding. It doesn’t include any assets with subjective values like goodwill or intellectual property and involves absolutely no forecasting.

Running the numbers on Avatar reveals that the stock is worth $32.86 per share. However, it’s currently only trading for about $20 per share. That means you can purchase the company for roughly 60 cents on the dollar.

Ben Graham would only purchase stocks trading at or below 65% of their NCAV. Or more simply, he only bought stocks trading for 65 cents on the dollar or less.

So as you can see, even by Ben Graham’s strict criteria, Avatar ranks as a buy.

Patience is a Virtue With This Housing Stock

I assure you that such disconnects don’t last indefinitely. Eventually, investors or an acquisition-hungry company will take notice and bid up the price.

That’s why the long-term performance of stocks trading below NCAV is so impressive, topping 35% per year since 1985.

However, I need to make one thing clear: Profiting from Avatar will require patience. After all, I’m not a complete idiot.

I recognize that the real estate crisis is far from over. Unsold homes, foreclosures and delinquencies continue to pile up. And now, even prime borrowers are behaving badly, defaulting on their loans. At the same time, sellers remain stubborn, which means prices need to fall even further.

That said, we’re much closer to a bottom than a top. And unlike almost every other homebuilder, Avatar is fundamentally fit to survive this downturn.

Avatar’s Management Goes on An Oscar-Winning Scavenger Hunt

Rather than acting like turtles, curling up in their shells until the crisis passes, Avatar’s management team is vulture-like, scavenging the land for historic discounts.

And the executives are finding them.

For example, take the company’s purchase of Seasons at Tradition in Port St. Lucie, Florida in September last year. Here’s what Avatar scooped up…

• 87 completed and partially completed homes.
• 267 developed lots.
• 364 partially developed lots.
• Approximately 400 undeveloped master planned lots.

Total cost: $7.4 million.

When the previous owner – the now bankrupt homebuilder, Levitt and Sons – defaulted on the property, the firm still owed $86 million. So in other words, Avatar picked up the assets at a 91% discount.

Avatar Holdings: Don’t Follow the Herd… Be Contrarian

With over three decades of experience in the field and a $213 million war chest, no doubt Avatar will uncover many more bargains in the months ahead.

The company’s other strategies include…

• Extreme Cost-Cutting Measures: Since 2005, management has slashed staffing numbers by 60%.
• A Retooled Business Model: This includes the abandonment of building McMansions in favor of smaller houses with less amenities at lower price points (i.e. the sweet spot of the future market).

It’s these kinds of things that should put Avatar in a perfect position to rake in profits when the real estate recovery finally materializes.

Avatar is perhaps one of my most contrarian picks. But I have no reservations making it…

• The company is well-capitalized. It’s sitting on almost $19 per share in cash.
• Insiders own a sizeable 22% stake, ensuring they’re in it for the long haul.
• The stock benefits from no analyst coverage – a harbinger of significant price jumps once a recovery takes hold and Wall Street finally clues in.
• Most important of all, we can buy shares – and an interest in over 16,000 acres in Florida and Arizona – on the cheap. The discount is legit, too, since real estate is carried on the books at historical cost and the majority of Avatar’s holdings were purchased prior to the peak in prices.

So fight your gut and be a contrarian. It’s time to buy residential real estate in Florida and Arizona. And when it comes to Avatar, even Ben Graham would agree.

Good investing,

Louis Basenese

P.S: The world is a-Twitter – and I’m finally joining the conversation. If you want to get my latest insights, recommendations and a glimpse of the research I’m reading – before I have a chance to write it all up for Investment U – you can follow me on Twitter.

It’s the only way to be the first to know what I’m watching, reading and getting ready to recommend. So make sure you’re in the loop. Hurry up and follow me here.

by Louis Basenese, Small Cap and Special Situations Expert

Wednesday, June 16, 2010: Issue #1282

With the World Cup currently going on in South Africa, you can compare investors to those poor guys who stand in the defensive wall at free-kicks: Nervously “cupping their groins,” as my colleague, Alexander Green, put it last week.

I can’t say I blame them. We’ve been in defensive mode ever since the “flash crash” on May 6. And with analysts like David Rosenberg inciting panic by suggesting that a 30% to 40% correction could be in the works, perhaps full-on body armor would be more effective.

But before you rush to liquidate your portfolio and scurry into an all-cash position, consider a great, lesser-known alternative. A safe, tried-and-tested way of earning stock market returns, using merger arbitrage funds…

Mergers & Acquisitions Help Share Prices Surge

Nothing jolts a stock higher than an unsolicited takeover offer. The target company’s share price can surge by 26%… 45%… even 67% in the blink of an eye.

The tricky part, of course, is identifying takeover targets before a deal is announced. Such a strategy is decidedly more speculative and isn’t suitable for investors in self-preservation mode.

So don’t try.

Instead, wait until after the takeover announcements are made public.

Yes, you can actually make money doing that. Good money, in fact, by using a strategy called “merger arbitrage.”

Merger Arbitrage: The Safest Way to Bet on the M&A Market

As I mentioned, once Company A announces plans to buy Company B, the share price of Company B immediately shoots higher. However, it doesn’t go up to the full offer price. Historically, it stops about 3% to 5% shy.

The reason this “spread” exists is straightforward:

• It’s the market’s way of pricing the time it will take to complete the deal.
• It also serves as a risk premium to compensate for the possibility of the deal falling through.

On average, though, only 16% of announced takeover deals fail to close. If you focus on friendly ones (meaning deals welcomed by management), the failure rate drops to roughly 5%.

Put another way, for 95 out of 100 takeovers, the spread is essentially risk-free money waiting to be claimed. All you have to do is buy shares of the target company after a deal is announced… and wait.

Once the deal closes, the cash equivalent to the full offer price will appear in your account. And you’ll have earned the spread in the process. Since the typical merger closes within four months, you can invest in several deals over the course of the year and earn a respectable double-digit return.

Skeptical About Merger Arbitrage? Don’t Be…

If you’ve never heard of merger arbitrage before, you’re probably skeptical at this point. You may even doubt that such a simple, straightforward strategy can work over the long term.

Let me put those fears to bed, once and for all.

Merger arbitrage is a battle-tested strategy. It’s been a mainstay in institutional and high-net-worth portfolios for decades. And that’s because it outperforms stocks and bonds, while taking dramatically less risk. In fact, about two-thirds less risk than investing in stocks, based on standard deviations.

Take Advantage of The Takeover Trend With Merger Arbitrage

Okay, so how do you take advantage of the takeover investing trend?

Don’t worry. This isn’t the part where I tell you to scan the daily headlines for takeover announcements in an effort to identify the best merger arbitrage opportunities. That requires too much time and effort – and I’d never leave you hanging like that.

No… this is the part when I tell you to hire a pro to do the heavy lifting for you. There are two funds with proven M&A track records…

• The Merger Fund (MERFX)
• The Arbitrage Fund (ARBFX)

Both are no-load funds with reasonable expenses, run by managers that have invested in merger arbitrage opportunities for over a decade.

And the results speak for themselves…

When disaster struck in 2008, both funds emerged virtually unscathed.

• The Merger Fund fell a mere -2.26%.
• And The Arbitrage Fund lost a scant -0.63%.

You can’t get better downside protection than that, while still staying invested in the market!

And of course, when M&A activity heats up, the funds deliver to the upside, too. When deal volume picked up after the 2003 recession, The Merger Fund jumped 11%, while The Arbitrage Fund jumped 15%.

Bottom line: If you agree that good defense can often be your best offense, don’t have a panic attack and make a hasty decision that undermines your long-term investment goals. Instead, consider merger arbitrage funds.

Good investing,

Louis Basenese

by: Louis Basenese: Small Cap & Special Situations Expert
Monday, June 4, 2010: Issue #1275

If it weren’t for Harry Markowitz’s Nobel Prize-winning research, which proved that diversification can account for more than 90% of portfolio returns, I wouldn’t own a single ounce of gold.

Why?

Because to me, gold epitomizes a “greater fool” investment. Its price is less a function of improving fundamentals and more a function of finding someone else (the greater fool) to pay you more for it.

Or as hedge fund manager, Julian Robertson, recently said: “It’s less a supply/demand situation and more a psychological one – better a psychiatrist to invest in gold than me.”

Gold investments come with baggage that others don’t carry…

The widely varying premiums that dealers charge for coins and small bars.

The hassle and cost of storage.

The lack of liquidity. (Next time you order a Big Mac, try getting change for a Krugerrand.)

So having listed these drawbacks, why am I writing a pro-gold column? I’ll tell you…

Momentum is Rampant… And the “Smart Money” Could Propel it Higher

We absolutely need gold (and other precious metals) in our portfolios to maximize our returns and minimize our risk. Especially now.

Over the past month, as fears of a Greek debt contagion spread and the Dow cratered by 1,000 points in a single day, we’ve seen a gold rush. The price zoomed to an all-time high above $1,230 an ounce.

Now I don’t have a crystal ball, but I can recognize momentum when I see it. And it rests squarely in gold’s favor.

In addition, the “smart money” group – hedge funds, insurance companies, high-net-worth individuals – is placing massive wagers that gold will head higher still.

We’re talking about guys like outspoken billionaire Jim Rogers and hedge fund guru David Einhorn of Greenlight Capital. Einhorn isn’t simply speculating, either. Gold represents the second-largest position in his $6 billion fund. Much of it is physical bullion, stored in a secret location near Times Square.

And then there’s John Paulson of Paulson & Co. The latest SEC filings reveal that Paulson alone holds $6 billion in gold-related assets. That’s more than 20% of his total portfolio. He owns more gold assets than Australia, Brazil and Romania.

As a rule of thumb, it’s often best to follow these leaders. In fact, their long-term track records suggest it’s stupid to do otherwise, given that they’re placing such big wagers…

Paulson, Einhorn and Rogers: A Trio of Big Bugs (Gold, That Is)

Let’s take a look at their stellar track records…

• Paulson: Successfully predicted the subprime market collapse – and pocketed $15 billion in a single year, as these toxic assets imploded.
• Einhorn: The guy was roundly lambasted for selling short Lehman Brothers before it was cool. But he made a mint when the Wall Street icon crumbled. It wasn’t a lucky call, either. Einhorn’s hedge fund has returned an average of 22% per year since 1996… after fees and expenses.
• Rogers: Most people know about The Quantum Fund that Rogers co-founded. It gained 4,200% in 10 years, while the S&P 500 Index only mustered up a 47% rise.

Bottom Line: Right now, some of the world’s smartest investors are practically betting the house that gold will rise higher.

Gold bug or not, it would be unwise to miss out on the action. And it’s not just these guys piling into the gold market either. Based on data from the World Gold Council, investment demand for gold has nearly quadrupled since 2007.

So what’s the best, safest way for you to join the party?

All Gain, No Pain

The good news is that you can position your portfolio to profit from gold – and silver and platinum, too – without putting a single penny at risk.

(Yeah, go ahead and read that again. It’s not too good to be true.)

Our friends at EverBank recently unveiled their latest innovative investment product. And when I say “innovative,” I don’t mean some kind of exotic product or complicated derivative.

The Jacksonville-based bank doesn’t offer that kind of landmine investment.

I’m talking about the MarketSafe Diversified Metals CD (Certificate of Deposit.) Here are the benefits…

• It allows you to participate in the appreciation of the spot price of gold, silver and platinum and is weighted equally, with 33% exposure to each.
• It has a low entry price. For a minimum investment of just $1,500, you can gain no-hassle exposure to precious metals.
• There are no management fees.
• Since this product is structured as a CD, it qualifies for FDIC insurance.
• It’s principal-protected. So if the precious metals rally wanes, we won’t lose a single penny.

Now you might recall that other “principal-protected” products became worthless when the issuer went belly-up. That’s not a concern here, though.

EverBank is well-capitalized. While the financial statements of most banks imploded in 2008, EverBank reported record net income and asset growth. In fact, if only all our financial firms followed the same diversified, conservative approach as EverBank, we wouldn’t have endured such a mess.

The only real cost is the opportunity cost of tying up your funds here instead of placing them into a traditional CD. And while it’s true that your money will be tied up for five years and gains will be capped at 50%, consider that the average five-year CD is currently paying 2.1%, according to Bankrate.com.

Personally, I’d be willing to give up that pittance for a potential 50% gain. And remember, your downside is completely protected. In my opinion, that’s more than a fair reward for taking no risk.

In the interests of full disclosure, Investment U does have an advertising relationship with EverBank. But even without it, I’d be recommending this product. It’s one of a kind. And in this case it provides the safest way to profit from the potential upside in precious metals.

So if you’re a gold skeptic like me – or a gold bug looking for another alternative entry into the market – I encourage you to check out more details on EverBank’s MarketSafe Diversified Metals CD. You can also call them directly at: 877.259.9014. Just be sure to reference code 11645 to identify yourself as an Investment U reader.

And don’t delay. The next funding deadline for this CD is Thursday, June 24.

Good (and smart) investing,

Louis Basenese

by Louis Basenese, Small Caps Expert
Friday, May 21, 2010: Issue #1265

Fight or flight?

Investors are choosing the latter.

Dare I say it, but after months of runaway markets and profits, some complacency had set in. But the tide is turning against them. Consider…

• The euro is crumbling. American stocks are following suit, with another spirit-crushing plunge on Thursday.
• Even the high-flying, perennial source of optimism – the Chinese stock market – is under assault. It’s officially entered bear market territory, as prices recently dropped 23.3% below the November 2009 high.

The headwind has rocked investors back on their heels a bit and they’re resorting to the flight instinct – into cash and (gasp) U.S. Treasuries, of all assets.

I don’t recommend you join them. Instead, step up to buy Japanese small-cap stocks. Here’s why…

Value Investing: Never En-Vogue, But Great During Turbulence

In Tuesday’s column, my colleague, Alexander Green, discussed the value investing concept. In it, he noted the work of Ben Graham and David Dodd, who argue that their method of value investing not only leads to higher returns, but also provides a “margin of safety.”

However, insisting on a “margin of safety” doesn’t simply mean fleeing into cash. That strategy doesn’t pay – especially now. The average savings account yields a paltry 0.87%, according to Bankrate.com. Not to mention, bailing into cash requires knowing precisely when to get back into the market, which is impossible. We don’t try to time the market – and neither should you.

Instead, keep this in mind: Deep value investments always perform best in the long run, based on three significant valuations…

• On a price-to-earnings basis, the cheapest stocks return 16.2% per year, compared to 6.9% for the most expensive and popular stocks (i.e. – “glamour” stocks).
• On a price-to-book basis, the cheapest stocks return 16% per year, compared to 8% for glamour stocks.
• On a price-to-cash flow basis, the cheapest stocks return 17% per year, compared to 8% for glamour stocks.

If you’re a pessimist, or non-believer, you can check out all the hard data behind these figures at The Brandes Institute.)

Now let me tell you how Japanese small-cap stocks fit into the equation…

Why Japanese Small Caps Are The Cheapest

Japanese small-cap stocks are some of the cheapest in the world right now…

• They’re trading at an historically low average price-to-book ratio of 0.86 – a 60% discount to the S&P 500.
• On a price-to-sales ratio basis, they’re trading at a 67% discount to the S&P 500.
• Even more compelling, you can find more of Ben Graham’s favorite investments – net-net stocks – in Japan than any other country in the world. I’m talking about companies that trade below their liquidation values. While the Nikkei languished for two decades, Japanese net-net stocks returned over 50%. You could have made a killing in Japan during its lost decades. All you had to do was focus on value stocks.

Net-Net Valuation Created by Ben Graham, this is arguably the purest way to gauge a company’s value. It basically measures a firm’s value based on its current net assets. It takes all cash and cash equivalents into account, then subtracts the value of accounts receivable and reduces total inventory to liquidation-like prices. Total liabilities are then subtracted from the total net assets to produce the net-net value.

These deep value investments boast an even more impressive long-term track record than run-of-the-mill value stocks. They returned an average of 35% per year since 1985.

And it’s not hard to understand why. After all, if I offered to sell you a 100-dollar bill for 50 bucks, you’d jump at the opportunity. Cash is cash. It has a known value.

And that’s what’s going on in Japan at the moment. Hundreds of stocks are trading at a price-to-book value below one. And since Japanese firms love to stockpile cash, this book value is “hard” – mostly in cash.

But bargains like this don’t last forever. It’s only a matter of time before investors scoop them up…

The Rodney Dangerfield of The Investment World

Japan is like the Rodney Dangerfield of the investment world – it gets no respect.

Of course, its economy and stock market hasn’t done much to garner a lot of respect over the past two decades. But right now, it’s clearly the cheapest and safest country to invest in. There just isn’t much more room for these stocks to fall.

However, there are plenty of reasons for them to jump higher…

• Improving GDP numbers.
• New leadership committed to economic reforms.
• Recovering domestic demand.
• A projected 64% jump in corporate profits.

As one fund manager reveals, “Investors still don’t like Japan, but there is gentle interest and sentiment is changing.”

Here’s a newsflash, though: The investors with that change of heart aren’t lightweights.

We’re talking about big names like Warren Buffett. He recently confessed that he “would like to make a large acquisition in Japan.” And the famed Tweedy Browne Global Value Fund (TBGVX) just scooped up two unnamed Japanese micro-caps because the bargains were irresistible.

Such moves by these mavens often precede massive shifts in sentiment. So don’t get caught off guard. The margin of safety in Japanese small-cap stocks is significant. So is the upside potential.

For tips on how to play this trend, check out another column of mine on Japanese small cap stocks, plus Alexander Green’s tips on how to invest in Japan’s economic revival.

Good (and safe) investing,

Louis Basenese

by Louis Basenese, Small Cap and Special Situations Expert
Friday, April 30, 2010: Issue #1250

Earlier this week, MarketWatch railed against investing in small-cap stocks.

And not just some small column buried in a deep, dark place on their website either… it was a feature article.

It states that investors might be “tempted to chase small-caps’ hot returns, be careful not to hop the last car of the train… small caps probably have seen their best days in this rally.”

Thanks for the oh-so prescient call, fellas. But why the heck should we believe you?

After all, I don’t recall you ringing the dinner bell to chow down on small caps in November 2008, December 2008, or January 2009, like I did.

Okay, enough of the self-promotion. But if the MarketWatch folks couldn’t spot the bottom back then, what makes them so sure they can predict the top now?

Yet there they are with their shamelessly bold article – “The Case Against Buying Small Caps Now.”

Let’s hit the courtroom and offer a legitimate rebuttal… with evidence that proves why now is still an attractive time to invest in small caps. Even better, I’ll share five easy tips to find the most compelling small-cap stocks in any market…

Hey, MarketWatch… Stick With the Facts, Not Opinions

~ Strike 1 Against MarketWatch: The article states that small-cap stocks have risen too far, too fast. Or as the publication puts it, “They’ve made a ton of money in a short time.”

But this is a hackneyed idea.

Need I remind you that this is exactly what everyone said about the current bull market in April last year. And that was after a mere 20% rebound off the bottom.

As you know now, they were dead wrong, providing yet another shining example of the checkered accuracy of the “too far, too fast” argument.

Small caps always trounce large caps coming out of a recession. Okay… not quite always. But 90% of the time, according to Standard & Poor’s, is close enough.

What’s more, this outperformance endures. For at least three years. And even up to 10 years, like it did following the nasty 1973-1974 recession.

So instead of investing based on a subjective assessment of how far is “too far” and how fast is “too fast,” I’ll stick with the hard data, thanks.

And it suggests that the small-cap rally could last for at least another two years.

The Trend isn’t Your Friend, Anymore

~ Strike 2 Against MarketWatch: “The trend is your friend,” right?

Well, not according to MarketWatch. It says this old Wall Street adage no longer applies because small caps have performed too well for too long.

As one of the experts quoted in the article states: “Small caps have led for nine out of the last 10 years… Prior cycle leaders are never the new cycle leaders.”

But the article offers no proof to back up this “never” claim. Instead, we get a bold prediction from investment manager GMO, which forecasts that returns for small-cap stocks over the next seven years will average less than 1% annually.

Really? Apparently, GMO has one powerful crystal ball. (Mine only sees two years into the future.) Not only that, it completely discounts the historical average annual small-cap returns of almost 13%, based on Ibbotson data.

I’m not about to take such a mighty leap of faith and bank on small caps performing completely out of sync with their long-term averages. Why? Because small-cap outperformance isn’t a trend… it’s fact. But one that MarketWatch fails to note.

The latest study from Bank of America Securities-Merrill Lynch found that small caps are the best asset class to invest in. Anytime. Period.

As Chief Investment Strategist, Richard Bernstein, summed it up: “Small-cap stocks offered the best risk-reward potential, regardless of time horizon” for the past 40 years.

I wouldn’t bet against that trend ending anytime soon.

MarketWatch Says to Check Your IQ At the Door

~ Strike 3 Against MarketWatch: My biggest objection to MarketWatch’s article is this: It assumes the average investor is an idiot.

Throughout the piece, it keeps mentioning that the best-performing small caps have been low-quality companies that almost went belly up in 2008. Or “companies with little or no earnings and in weaker financial shape.”

It asserts that buying these companies now would be a recipe for disaster.

Well, duh, Captain Obvious! The last time I checked, nobody said, “Let me go find a small-cap stock with garbage fundamentals to buy.”

We’re informed investors. We know that any old small cap won’t cut it. But MarketWatch apparently doesn’t give us that much credit.

But forget them. And the experts they rode in on, especially Ed Yardeni. He would like us to believe that, “If you jump in [to small caps] now, you’re not getting any bargains.”

That’s categorically untrue.

If you’ve got $20, you can scoop up 102 bargains by buying the Dreman Contrarian Small-Cap Value Fund (DRSVX). The average small cap in the fund trades at a price-to-earnings (P/E) ratio of just 14. That’s a 33% discount to the long-term average P/E ratio for small caps.

In other words, they’re cheap.

That’s three strikes. MarketWatch… you’re out.

If you want to get your hands dirty and uncover individual small-cap gems, here are five easy tips to do so…

Five Tips to Profit From Small Caps

When it comes to small cap stocks, I recommend focusing on companies with these five characteristics:

#1: Little/No Debt:

Given the havoc that credit crisis wreaked and the countless bankruptcies that resulted as cheap financing vanished, it’s best to avoid companies that rely heavily on debt.

Instead, stick with small caps that have little (or no) debt.

Look for a debt-to-equity ratio below 0.3. This alone will narrow down your choices significantly. And it will also (dramatically) reduce your risk.

#2: Prefer Pioneers:

Companies can create products to compete in existing markets. Or they can create products that are so revolutionary and timely that they launch their own markets and trends.

The latter obviously positions the company, and in turn investors, to reap the most profits.

Think of firms like Intuitive Surgical (Nasdaq: ISRG), Google (Nasdaq: GOOG), even VMware (NYSE: VMW).

#3: Sustainable Competitive Advantage:

We’re not looking for one-hit wonders. We want small caps that will become mid caps and eventually, large caps.

But to do so, it requires a sustainable competitive advantage – whether that’s through revolutionary products, an insurmountable first-mover advantage, or extremely high barriers to entry.

Anything that protects the underlying business from competition and enables the company to do the most important thing of all – increase earnings by a healthy double-digit rate.

#4: Within Three Years of an IPO (or Major Index Listing):

Smaller and/or newer companies have more room to grow. Plus, Wall Street tends to overlook many of these firms. By focusing on these young and virgin opportunities, we can actually profit ahead of the Wall Street institutions and the trillions in capital they control.

#5: Earnings… Earnings… and More Earnings:

Share prices ultimately follow earnings. By focusing on companies with the strongest growth profiles, we set ourselves up for the most dramatic gains.

Enough With the Small-Cap Bashing

Despite what the mainstream financial press would like you to believe, it’s possible to profit from small caps in any environment.

I hope you find these tips helpful. They’re just a small sample of the criteria that we use at The White Cap Report to select small-cap stocks for our portfolio.

If you don’t have time to scour the markets each day in search of the most compelling opportunities, take a few minutes to check out our White Cap strategy. And if you like what you see, consider jumping on board.

Members of The White Cap Nation just locked in an 88% stock gain in Acme Packet (Nasdaq: APKT). And we’re getting set to release our May issue on Monday, with another under the radar, small-cap stock that has equally strong promise.

Good (small-cap) investing,

Louis Basenese

by Louis Basenese, Small Cap and Special Situations Expert
Thursday, April 15, 2010: Issue #1239

Last April, I insulted some people when I wrote a column, suggesting that we were at “the start of a new bull market.”

For example…

• Gale W. refused to believe it because “the smartest analyst in the world” – not me – was telling her otherwise.
• Lee S. wished I were right. But he wasn’t willing to bet on it.
• And my favorite responder, Henry P., said, “Basenese must live in a parallel world, but one that is different, one in which delusion replaces reality… people that listen to you are going to be in for a very rude awakening.”

Well Henry, if a 74% rally is a rude awakening, I’ll let Chip from Animal House respond for me: “Thank you, sir! May I have another?”

Bottom line: This time last year, nobody wanted to believe that the fledging rally would continue. Pessimism prevailed. And they were dead wrong.

I believe the same thing is about to happen again…

Déjà Vu All Over Again

Even after 13 months of gains, countless investors still have no faith. They doubt the current bull market is sustainable. So much so, they even refuse to call it a bull market.

According to 249 news headlines over the past month, it’s a “melt-up.” (Melt-up? Could there be a phrase that oozes with more skeptical connotations?)

I’ve also heard it labeled “a cyclical bull market in a secular bear market.” Puh-lease! If a 74% rise for the S&P 500 doesn’t qualify as a full-blown bull market, nothing does.

If you share these doubts, stop kidding yourself. We’re in the midst of an historic bull market. One that’s very likely to continue. And here are seven reasons why…

1. It’s All About the Economy, Stupid!

Forget about a double-dip recession cutting off this rally at the knees. The latest economic data points to a recovery that is real and sustainable.

• Take Warren Buffett’s favorite indicator, for example – railroad freight traffic. It just hit its highest level since November 2008 – up 16.5% in the last week of March.
• Restaurant activity rose to its highest level in 27 months in February, according to the National Restaurant Association.
• The ISM Manufacturing Index touched a six-year high last month.
• New orders for manufactured durable goods increased for the third consecutive month, too.
• Industrial production jumped by a solid 2% in February.
• Last month, chain store retail sales logged their best year-over-year increase since 1999.

True, the unemployment picture still stinks. But it’s a lagging indicator. By the time it improves dramatically, the market will have left you in the dust.

2. The “Sesame Street” Indicator is Bullish

Oscar the Grouch loves trash! So do investors.

Case in point: The stocks that got battered and bruised the most during the market’s downturn are the best-performing ones coming off the bottom. Namely, financial stocks. In fact, most are up by double the amount of the S&P 500, if not more.

Of course, this typically happens in the first leg of a bull market. Junk outperforms high-quality companies. But it’s a well-documented fact that investors eventually start rotating into undervalued, steady performers.

There’s plenty of history to back this theory up, too. That’s exactly what happened after the early 1980s recession, the early 1990s recession and the early 2000 downturn, as well. The fact that it hasn’t happened on this occasion yet, means there’s plenty more upside ahead, as high-quality companies eventually take the baton.

3. Technically Speaking…

Although I favor fundamental analysis over technical analysis, that doesn’t mean I ignore technicals completely. After all, we never want to fight the trend. And technicals point to this rally continuing, too.

Take the advance/decline line, for example. It basically gauges the strength of a rally by measuring how many stocks are participating in it (also referred to as the market’s “breadth”). The line is currently very bullish. The last three times it’s been this bullish – in 1962, 1975 and 1982 – the market kept charging higher, according to Dan Sullivan of The Chartist. All the while, investors doubted the sustainability of the move.

Then there’s the common Wall Street wisdom to “never short a dull market.” In other words, don’t bet on a downturn just because it’s been a while since we had one. The bears would like you to believe that the market is overdue for a downturn, since we’ve gone 27 trading days without a 1% move. Let me put their argument in perspective…

We’re not even close to longest streak on record. Back in 1995, the S&P 500 went almost 100 days without a 1% move. So this “dull” market could keep heading higher for many, many more days.

4. Bring on the Stock Buybacks

Companies are spending the lowest proportion of their money on stock buybacks in almost a decade – 28% of operating profit. At the same time, they’re sitting on record amounts of cash – almost $1 trillion.

The good news is we’ve seen a pick-up in buyback activity in recent months. Mizuho Financial Group expects companies to double their stock repurchases this year – resulting in a total of $235 billion. We’re nowhere near a top, either. In 2007, companies spent almost $600 billion on buybacks.

Remember, buying back shares reduces the number of shares available and increases earnings by share. As a result, stocks often climb higher.

Long story short… the speed of buybacks is accelerating and there’s ample cash available to fuel many more. That definitely points to higher share prices ahead.

5. Stocks Are (Still) Cheap

The S&P 500 currently trades for about 15 times this year’s projected earnings, based on Bloomberg Data. If companies deliver the profits they’re promising, shares will need to rise in order to match the average price-to-earnings ratio of 20.6 since 1992.

Looking at this from another angle, we always tell members of The Oxford Club that share prices ultimately follow earnings. And with the average analyst in a recent Bloomberg survey calling for a 50% increase in S&P 500 earnings this year, stock prices could easily jump just as high.

6. Life Expectancy

The fact that the current bull market is now one year old is a big deal. The last 13 bull markets that lived that long ending up lasting an average of 4.4 years and returned 153%. This bull is still a baby in comparison.

7. The Herd is Clueless (Again)

We all know it’s bad to follow the herd. And right now, the herd is clueless. The entire time the market’s been heading higher, they’ve been plowing their money into bonds!

The latest data from Morningstar reveals that over 95% of the $377.4 billion flowing into mutual funds last year went into bond funds. Year-to-date money flows are similarly lopsided, with 71% going into bond funds.

Even worse, investors are withdrawing money from stocks to fund this strategy. In February, investors withdrew $3.7 billion from U.S. equity funds, the fifth outflow in six months.

So if you’re selling now, you’re investing right alongside the herd. Bad idea.

Be Invested Or Be Sorry

In the end, if you doubted my prediction last spring and sat on the sidelines, you missed out on a massive rally. Another bout of hesitance could mean missing out on more upside, which would be even more disastrous to your wealth.

So make sure you have some exposure to equities. Just be smart about it. Do these two things…

• Use position sizing.
• Use trailing stops.

By doing so, you’ll share in all the upside if I’m right. And if I’m wrong, you’ll limit your losses.

In my mind, that’s a far better proposition than running scared, parking everything in cash and getting paid nothing for it. As the saying goes, “Nothing ventured, nothing gained.”

Good investing,

Louis Basenese

Editor’s Note: Forget Wall Street’s screwball terms for it… we’re in a bull market, folks. So now that you know this, where are you going to invest your money to get the maximum amount of profit?

Louis Basenese has plenty of ideas for you. And he profiles them all in The White Cap Report. He’s a master at uncovering companies that few people are paying any attention to – oftentimes, trail-blazing small-cap firms on the cutting-edge of innovative new technologies, or with unique products.

For just $50 a year, you get all of Louis’s picks, plus those of fellow Investment U editors, Karim Rahemtulla and Marc Lichtenfeld. What’s more, you have nothing to lose by giving it a try – we’ve got a risk-free, money-back guarantee. Take a look at The White Cap Report.