In the last week, we've experienced two of the worst trading days since the market crash of 1987. While there has been a lot of panic, we at Money Morning are working diligently to help investors navigate this downturn.
Today, we're talking with Money Morning Special Situation Strategist Tim Melvin. He'll explain what you can do right now to not only protect your wealth, but also profit in the short term and long term from the economic downturn caused by COVID-19.
Tim has a long-term investment mindset and has navigated investors through the 1987 crash, the dot-com bubble, and the 2008 financial crisis.
Here's how Tim is handling these markets now.
Buy-and-Hold Investing Is More Important Than Ever
Money Morning: What is the first thing that you think investors should do with their portfolios?
Tim: Nothing. Absolutely nothing. It's too late. This happened too fast. We've shed 30% of market value in less a month.
The damage is even greater in small companies. We are finally seeing the impact of the ETF selling pressure that we've discussed. There is a lot of indiscriminate selling, and there are no buying pressures right now.
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But if you're an investor, the best thing to do is to sit back and just wait until we have more clarity. The market will eventually recover. How long that will take is hard to know at the moment. After all, this is the sharpest contraction into a bear market in history (21 days compared to the more than 40 in 1987, which was the previous record).
If you own a portfolio of good companies with healthy balance sheets, you're going to be fine over the long term.
Money Morning: Do you think we have reached a bottom yet?
Tim: This market started falling from very high levels. I said in January that the market was trading at 25 times earnings at the start of the year. That is higher than historical averages of 16 times earnings. So, it wasn't a question of if a pullback was coming, but when. I have said for over a year now that most stocks were too high, but there was no reason for stocks to go down. The coronavirus gave the market a reason to fall, and prices reacted very quickly to the health and financial dangers of this virus.
I said not too long ago, the market would probably have to be around 2,100 to trade at fair value. When I said that, the S&P 500 was over 3,000.
There are still a few hundred points until we say that this is a buyable moment. Right now, I think it is best to just sit still, take a breath, and focus on other things.
Money Morning: When the markets were calm in January, you did come up with a way for investors to make huge gains. Back in January, you set up an inexpensive trade for MaxWealth readers that has returned a 1,200% gain shorting the S&P 500, 500% shorting junk bonds, and 1,200% on the VIX. Walk us through that trade.
Tim: That was a black swan trade. All I did was sit down and look at the world and think about what is happening that people are mispricing. At the time, the S&P 500 was still at elevated levels. The VIX was extremely low. And junk bonds were trading like they were investment grade. I looked and saw that markets were seriously underpricing the possibility of a massive market shift.
I thought if we got a serious pullback, readers could make five, six, seven times their money. But the world has lost its mind. We're now looking at 1,200% returns, and there is still a lot of potential to make more.
The VIX option doesn't expire until November, and the S&P doesn't expire until 2022. So, we can take profits off the table, and still make money if this continues to decline.
Money Morning: Are those types of trades available right now in the market?
Tim: At the moment, options are limited because the VIX sits at 75. This is not the time to be buying calls and puts, but rather selling them. If there is something that is extremely attractive, you will want to buy the stock and sell the calls. Or you can sell puts another 20% lower on things you would want to buy for the long term.
Money Morning: You are a big advocate of private equity firms over the long term. We've seen KKR & Co. Inc. (NYSE: KKR) and Carlyle Group Inc. (NYSE: CG) stock get hammered. But you think they're great buys over the long term. What is going on in this space?
Tim: Last year, the industry raised over $300 billion in commitments to private equity investments. As a result of his success, the industry entered the year with over $1 trillion in dry powder.
But all that money created a problem. With valuations surging, too much money chased too few ideas. Buyouts became extremely difficult due to valuation concerns. Dry powder accumulated.
Firms do not start earning fees until they deploy cash, so private equity dry powder wasn't delivering returns.
Valuations have been cut dramatically by the market sell-off. They will likely spill over into private markets before we find a bottom.
The flood of retail closings and supply chain issues may tip the U.S. economy into a recession. This will lower valuations further and create attractive risk-reward setups for buyout investors.
There is a caveat to the development. There will be fewer private equity firms when this crisis is over.
To keep potential returns in the zone that attracted investors in the first place, some firms increased the amount of leverage they used when structuring deals. Many of those highly levered deals will fail. This will take the private equity firms right down with them. Those that have substantial allocations and energy combined with too much debt will find it difficult to remain viable.
The remaining firms that resisted the urge to chase deal pricing higher could find themselves in a buyer-friendly climate with fewer competitors.
Money Morning: Are any of these firms ones that you want to buy and hold for the next 24 months? What would it be?[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
Tim: While it is best to do nothing in your investment account, there are some black swan type options selling opportunities.
I like the long-term future of KKR, one of the oldest and most successful private equity firms. Right now, no one seems to think private equity will ever work again, and the price of KKR shares has plummeted.
As one of the oldest and most successful private equity firms, I suspect it will not only survive, but earn huge returns for its investors due to its ability to deploy capital in a bad market. I am not the only one excited about the future, as the CO just spent $1.5 million buying shares in the open market. We can use the inflated option premium as a chance to leg into a position that could pay off in a very big way over the next few years.
Figure out how much you want to invest in shares of KKR. Take 25% of that money, and buy stock now right now. Immediately sell June call options against the shares to create a covered call.
As I write this, the June $27 calls last traded at about $1. If this stock gets called away, you will have a gain of roughly 40% from today's price.
Option markets are moving fast, so be very aware of what you're getting paid when you put on the trades, and adjust the strike price as required. You want to get at least 5% of the current price of KKR stock.
Now take 50% of the money you can invest in KKR and set aside for margin in your options account.
As I write this, you can sell the June $17 put option for about $1.50. Sell the puts and put up 100% of the purchase price. This is called a cash-secured put trade. Once again, due to fast-moving markets, be sure to get at least 5% of the underlying share price in premium.
If the VIX is still high, sell covered calls against those shares three months out and at least 30% above the price at the time.
If and when the next 50% is put to you take 25% of your stake and sell a three-month put that is 20% or so out of the money at the time. When that is put to you, you will have established a full position in the stock and collected option premiums to further reduce your cost basis in the stock. The initial premiums from the sales of the call and the cash-secured put alone amount to close to 12% of the current price, and the next option sales will merely add to that amount.
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