The pitfalls of financial innovation... Investment trusts of the 1920s... 'AAA'-rated junk... Quick-buck ETFs... Know-nothing touts... The financial reckoning...
 It's a theme that pops up time and time again...
In almost every generation, you'll find some genius on Wall Street who comes up with an "innovative" way to easily make money. Most of this innovation is just old wine in new bottles... Someone takes an investment vehicle previously seen as boring and conservative... and turns it into a leveraged pile of toxic waste. And almost like clockwork... bankers, governments, and investors make the same dumb mistake and learn the same painful lesson. "Financial innovation" has featured in most of the big market crashes of the past century. Take the Wall Street Crash of 1929... The popular financial innovation of the 1920s was investment trusts. As Maury Klein writes in his classic novel Rainbow's End: The Crash of 1929: New financial vehicles arose to help newcomers put their money into stocks, the most notable being the investment trust. This early version of the modern mutual fund was designed to coax money from small investors who, lacking the capital and expertise to acquire a diversified portfolio, were invited to put their money in a company created to invest in other companies for them. The trusts started out innocently enough. But by the late 1920s, many trusts were using leverage and often selling for more than the value of the underlying stocks, bonds, mortgages, and other securities they contained. In his book The Great Crash, 1929, economist John Kenneth Galbraith writes: By the summer of 1929, one no longer spoke of investment trusts as such. One referred to high-leverage trusts, low-leverage trusts, or trusts without any leverage at all. Galbraith illustrates a hypothetical trust started in early 1929 with $150 million with one-third of the trust made up of common stock, one-third preferred stock, and one-third bonds. Given the market's rapid ascent, by later that year, the common stock could have risen in value by 150% on a 50% increase in the value of the underlying securities. Some trusts even used leverage to buy the shares of other trusts. Galbraith says: Were the common stock of the trust, which had so miraculously increased in value, held by still another trust with similar leverage, the common stock of that trust would get an increase of between 700 and 800 percent from the original 50 percent advance. And so forth. Galbraith ultimately notes, "leverage, it was later to develop, works both ways." Goldman Sachs and its investors found that out the hard way. It raised $100 million for a trust that was sold to the public at $104 per share in December 1928... peaked above $222 per share in February 1929... and traded some years later at $1.75. Then there were junk bonds... Junk bonds have been around since our nation's founding. The new republic was under high risk of default and had to pay high rates of interest to attract lenders. But most investors had no idea junk bonds existed until they gained new popularity in the 1970s and 1980s. Inflation had ravaged corporate America throughout the 1970s, creating many "fallen angel" companies that lost their investment-grade credit ratings. They were now junk rated. Investment firm Drexel Burnham Lambert helped fuel the junk bond market's hypergrowth from $10 billion in 1979 to $189 billion by 1989. Of course, it all blew up, and the firm's "junk bond king," Michael Milken, went to prison on 98 counts of fraud and racketeering. Junk bond default rates soared from 2.2% during the hypergrowth period to 10% in 1990 and 9% in 1991. Since 1980, the junk bond market has blown up no less than five times. If you're my age, you might remember the two junk bond busts of the 1980s as the savings and loan crisis played out. The dot-com bust was also a big junk bond bust. Credit default swaps played a big role in the failure of insurance giant American International Group (AIG)... Credit default swaps ("CDS") are essentially insurance policies on bonds. If you think of it like homeowner's insurance, it's almost like a highly leveraged way of buying a home under certain circumstances. For example, when a home burns to the ground, the insurance company on the hook for the payment is effectively in the same position as an uninsured homeowner. AIG sold billions of CDS leading up to the great financial crisis. Then the housing bubble burst and home values fell. When bad mortgage debts blew up during the crisis, AIG took the losses. It lost $99 billion in 2008 and eventually required more than $180 billion in bailouts. At the time, I remember AIG CEO Hank Greenberg saying something silly like AIG wasn't insolvent, it was just illiquid – as though there's a difference. Either you can pay your debts or you can't. And if you can't, you're insolvent. I know what you're thinking... Many folks can't afford to pay off their houses today. Are they insolvent? Not as long as they can make their payments. But for most folks, losing their job and not finding a new one would quickly render them insolvent. Collateralized debt obligations also played a role in the 2008 crisis... During the housing bubble, homebuyers who never should have been lent a penny took on massive debts... which were then sliced and diced into complex mortgage derivatives called collateralized debt obligations ("CDOs") that were rated "AAA" securities by the likes of Moody's, Fitch, and Standard & Poor's. The ratings were questionable, since the derivatives contained tranches of risky subprime mortgage debt. CDO "tranches" were based on risk, with the riskiest tranche at the bottom and the safest at the top. The bottom tranche absorbs losses first, then the next one up, and so forth. I won't claim to truly understand them. As Warren Buffett once pointed out: When you start buying tranches of other instruments, nobody knows what the hell they're doing. By 2009, CDOs accounted for more than $500 billion in losses at financial institutions. More than half of AAA-rated CDO tranches issued between 2005 and 2007 were downgraded to junk ratings or incurred losses to their principal. In total, AAA-rated CDO tranches lost $325 billion during the great financial crisis. Innovation tends to reflect the financial knowledge at the time... Leverage and trusts seemed like a revelation in 1929. High-yield debt seemed exotic in the 1980s. CDS and CDOs reflected the advanced mathematics that had taken over Wall Street by the early 2000s. Meanwhile, the signature innovation of the past decade has been the rise of the exchange-traded fund ("ETF"). Global management consulting firm Oliver Wyman calls the growth of ETFs "the single most disruptive trend within the asset management industry over the last 20 years." The number of ETFs has more than doubled from 1,568 in 2015 to 3,378 today. The number has risen 26-fold since 2003. You can buy ETFs for just about any asset: stocks, bonds, futures contracts, currencies... you name it, there's probably an ETF for it. Just like with the 1929 trusts, ETFs started out innocently enough. But they've evolved into leveraged monstrosities. Today, you can buy ETFs leveraged to provide as much as 5 times the performance of the underlying securities. A company called Leverage Shares has issued ETFs to provide 5X leverage to the S&P 500 Index, Nasdaq Composite Index, and "Magnificent Seven" stocks. A wave of ETFs also provides exposure to various markets using derivatives. These, too started out innocently enough and include such mundane strategies as covered-call writing. A recent Bloomberg article indicates that the ante has been upped, reporting: Across platforms like TikTok, YouTube and Reddit, financial influencers are promoting a new way to speculate in the stock market — touting payouts that, at first blush, can top 100%, or more. The tenor of our time is right there in a single sentence... social media... influencers... heavy promotion... speculation... and the promise of big, fast money. All the excitement is about what Bloomberg calls, "quick-buck ETFs." Many of them include the simple application of leverage to an existing portfolio or single stock. For example, the T-Rex 2X Long MSTR Daily Target Fund (MSTU) provides twice the daily performance of a company called MicroStrategy (MSTR)... whose well-known founder and executive chair Michael Saylor has invested a large amount of the company's treasury in bitcoin. So the stock is essentially a bitcoin proxy... and the new ETF provides you with 2X leverage on it. But it gets worse... There's a whole range of ETFs centered around the idea of selling options as a source of income. YieldMax ETFs have a few dozen funds that do this for single stocks. One of them is the YieldMax COIN Option Income Strategy Fund (CONY), which sells options on cryptocurrency broker Coinbase (COIN). So far this year, the fund has paid cash dividends of more than 100% of its current share price. Now, everyone knows that a high yield indicates a high level of risk – although YieldMax certainly isn't going out of its way to tell investors this. On its web page for CONY, it shows the distribution rate as 99.67%, printed in large, bold type. It sounds wonderful, but if you bought the stock on January 1, you'd have lost money on it. You see, while the dividend payout was huge, the stock itself is down more than 52% since then. Its monthly dividend peaked in April at $2.79 per share and has since fallen to about $1. In the fine print farther down the page, printed in darker, harder-to-read type, it says the distribution rate is what you'd earn if the last dividend payment remained the same going forward. As we've already noted, its dividend fell roughly 64% from April through September, pushing the stock price down 57% from its March 28 peak to yesterday's closing price. Interestingly, the 30-day U.S. Securities and Exchange Commission yield for CONY is currently listed at 3.7%, reflecting the amount of income earned by the fund over the past 30 days. Both yields are made-up nonsense. CONY's ability to generate income depends entirely on the price movement of the shares relative to the strike prices of the options it sells. That's why the income has dropped so much. And since folks only buy it for the income, every month that the income drops, folks sell the stock for fear it'll continue falling. If investors wanted to bet on Coinbase, they'd have been better off just buying the stock. It's up about 4.7% from January 1 through yesterday's close. The stock pays no dividend. But let's face it, this isn't about steady income. It's just another form of speculation, using the inherent leverage of options to try to make a lot of money fast. Bloomberg's "quick-buck ETF" label is spot on. Bloomberg reports that a record 164 derivatives-based ETFs have launched this year. Firms have filed to launch as many as 25 at once and assets in them have grown sixfold in the past five years, to $300 billion. What would a financial innovation be without know-nothing touts? "Investor" Todd Akin runs a YouTube channel that seems to exist solely to tout YieldMax products. He claims he's making $500,000 a year in dividends, "living financially free out of our brokerage accounts." He recommends viewers e-mail him for his guide on how to do this. He then admits that he has margin debt of $430,000. It was $400,000, but he has been "adding to names on the dips." Like Wall Street did with investment trusts in the 1920s, Akin is touting YieldMax funds to "small investors who, [lack the] capital and expertise to acquire a diversified portfolio." It reminds me of an unconfirmed, but frequently told, story about Joseph P. Kennedy, father of the famous politicians John F. Kennedy, Robert Kennedy, and Edward Kennedy. Joseph made a fortune during the 1920s bull market with his "ruthless, razor-sharp mind." But in 1929, Joseph started getting nervous about the stock market. He spoke with several of the leading investors of the era, then with the heads of several Wall Street brokerage firms. They were all wildly bullish, but he still had his doubts. Then one day Joseph stopped on Wall Street to have his shoes shined by Pat Bologna, known as "the investing shoeshine man." Bologna gave Joseph a tip to buy oil and railroad stocks. Joseph went home and told his wife that, "a market that anyone could play and a bootblack predict" was not for him. Whether the story is true or not, Joseph sold before the crash. Meanwhile, Bologna put his entire life savings of $5,000 into a single stock, National City Bank (Citigroup's predecessor), on margin. A 10% margin was typical of the time, so Bologna could have bought $50,000 worth of stock. When he could no longer afford the margin as the market plummeted, he sold all his stock and wound up salvaging $1,700. He kept his shoeshine stand at 60 Wall Street. Like Bologna, Akin has no idea the amount of risk he's taking. He'll wake up one day with a notice in his account informing him that the brokerage has sold all of his position because its value has fallen below the amount of margin debt he owed. He'll have nothing left. Someday, lots of folks like Akin will face margin calls. People who know nothing are leveraging up and buying securities with risks they don't understand, in the belief that it's easy money. This has never ended well in the past and it won't end well this time, either. I won't make any predictions about when the reckoning will arrive... As I pointed out last week, it's hard to be too bearish with the Federal Reserve, European Central Bank, People's Bank of China, and central banks in Canada, New Zealand, Switzerland, Sweden and the U.K. all cutting rates. So a flood of global liquidity is likely about to be unleashed. However, all this easing is arriving with markets at exorbitant valuations and speculative behavior running rampant. Those are the usual conditions at the end of a bull market, not the beginning of one. And of course, interest-rate cuts generally signal weakening economic conditions and have often accompanied bear markets. Put it together, a bear market seems as likely as a Melt Up. So risk is high. You might get a big return for taking that risk. But you might also take a big loss. We could be looking at the mother of all blow-off tops... or a sudden, severe market crash that punishes overleveraged, know-nothing investors who've borrowed massive sums of money. Remember, the market sucks in the maximum number of victims, makes them believe getting rich in stocks is easy, then cuts them off at the knees before they know what's happening. It's not time to swing for the fences. It's time to focus your portfolio on the best businesses... and to be careful that you're not overpaying for them. No matter what the market does, that strategy will help you preserve and grow your capital at healthy rates over the long term. And if you're looking for some of the best businesses today, I urge you to check out my latest presentation here. It details a small group of stocks that could thrive during a market downturn. Current Extreme Value subscribers can find my latest research here.
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New 52-week highs (as of 10/10/24): Alpha Architect 1-3 Month Box Fund (BOXX), Ciena (CIEN), Commvault Systems (CVLT), CyberArk Software (CYBR), Kinross Gold (KGC), Kinder Morgan (KMI), Cheniere Energy (LNG), Torex Gold Resources (TORXF), Texas Pacific Land (TPL), and The Trade Desk (TTD). In today's mailbag, opposing views on our "China Explainer" from the past two days (here is Part I and Part II)... What's on your mind? As always, e-mail us at feedback@stansberryresearch.com. "Mercy, can you learn to write using KISS principles? Why do you have to keep on writing lengthy and [have an] additional link with other discussions?... Create something that has value or do not write at all." – Subscriber Mike T. "That was a great interview! Lots of insightful information... Thanks again." – Subscriber Steven S. Good investing, Dan Ferris
Eagle Point, Oregon
October 11, 2024
Stansberry Research Top 10 Open Recommendations Top 10 highest-returning open stock positions across all Stansberry Research portfolios. Returns represent the total return from the initial recommendation. | Investment | Buy Date | Return | Publication | Analyst | MSFT
Microsoft | 11/11/10 | 1,366.5% | Retirement Millionaire | Doc | MSFT
Microsoft | 02/10/12 | 1,325.8% | Stansberry's Investment Advisory | Porter | ADP
Automatic Data Processing | 10/09/08 | 1,035.9% | Extreme Value | Ferris | BRK.B
Berkshire Hathaway | 04/01/09 | 706.6% | Retirement Millionaire | Doc | TT
Trane Technologies | 04/12/18 | 526.6% | Retirement Millionaire | Doc | WRB
W.R. Berkley | 03/15/12 | 504.7% | Stansberry's Investment Advisory | Porter | AFG
American Financial | 10/11/12 | 470.4% | Stansberry's Investment Advisory | Porter | HSY
Hershey | 12/07/07 | 467.1% | Stansberry's Investment Advisory | Porter | TTD
The Trade Desk | 10/17/19 | 419.3% | Stansberry Innovations Report | Engel | PANW
Palo Alto Networks | 04/16/20 | 383.0% | Stansberry Innovations Report | Engel | Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any Stansberry Research publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio.
| Top 10 Totals | | 4 | Stansberry's Investment Advisory | Porter | | 3 | Retirement Millionaire | Doc | | 2 | Stansberry Innovations Report | Engel | | 1 | Extreme Value | Ferris |
Top 5 Crypto Capital Open Recommendations Top 5 highest-returning open positions in the Crypto Capital model portfolio | Investment | Buy Date | Return | Publication | Analyst | wstETH
Wrapped Staked Ethereum | 12/07/18 | 2,291.8% | Crypto Capital | Wade | BTC/USD
Bitcoin | 11/27/18 | 1,501.6% | Crypto Capital | Wade | ONE/USD
Harmony | 12/16/19 | 1,130.2% | Crypto Capital | Wade | POL/USD
Polygon | 02/25/21 | 717.1% | Crypto Capital | Wade | CVC/USD
Civic | 01/21/20 | 371.3% | Crypto Capital | Wade | Please note: Securities appearing in the Top 5 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the Crypto Capital model portfolio. The buy date reflects when the recommendation was made, and the return shows its performance since that date. To learn if it's still a recommended buy today, you must be a subscriber and refer to the most recent portfolio.
Stansberry Research Hall of Fame Top 10 all-time, highest-returning closed positions across all Stansberry portfolios | Investment | Symbol | Duration | Gain | Publication | Analyst | | Nvidia^* | NVDA | 5.96 years | 1,466% | Venture Tech. | Lashmet | | Microsoft^ | MSFT | 12.74 years | 1,185% | Retirement Millionaire | Doc | | Inovio Pharma.^ | INO | 1.01 years | 1,139% | Venture Tech. | Lashmet | | Seabridge Gold^ | SA | 4.20 years | 995% | Sjug Conf. | Sjuggerud | | Nvidia^* | NVDA | 4.12 years | 777% | Venture Tech. | Lashmet | | Intellia Therapeutics | NTLA | 1.95 years | 775% | Amer. Moonshots | Root | | Rite Aid 8.5% bond | | 4.97 years | 773% | True Income | Williams | | PNC Warrants | PNC-WS | 6.16 years | 706% | True Wealth Systems | Sjuggerud | | Maxar Technologies^ | MAXR | 1.90 years | 691% | Venture Tech. | Lashmet | | Silvergate Capital | SI | 1.95 years | 681% | Amer. Moonshots | Root | ^ These gains occurred with a partial position in the respective stocks.
* The two partial positions in Nvidia were part of a single recommendation. Editor Dave Lashmet closed the first leg of the position in November 2016 for a gain of about 108%. Then, he closed the second leg in July 2020 for a 777% return. And finally, in May 2022, he booked a 1,466% return on the final leg. Subscribers who followed his advice on Nvidia could've recorded a total weighted average gain of more than 600%.
Stansberry Research Crypto Hall of Fame Top 5 highest-returning closed positions in the Crypto Capital model portfolio | Investment | Symbol | Duration | Gain | Publication | Analyst | | Band Protocol | BAND/USD | 0.31 years | 1,169% | Crypto Capital | Wade | | Terra | LUNA/USD | 0.41 years | 1,166% | Crypto Capital | Wade | | Polymesh | POLYX/USD | 3.84 years | 1,157% | Crypto Capital | Wade | | Frontier | FRONT/USD | 0.09 years | 979% | Crypto Capital | Wade | | Binance Coin | BNB/USD | 1.78 years | 963% | Crypto Capital | Wade | | 
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