I think we can all agree that it would be ideal to be able to fund a comfortable retirement 100% from safe and growing dividends. That way you will be able to sleep well at night even in the most severe bear market because no matter how low stocks drop your portfolio’s income would be unaffected. My own high-yield income growth retirement portfolio is based around this goal and uses three time-tested investing principles:

• High and safe yield (5+% portfolio goal)
• Fast long-term dividend growth (10+%)
• Good companies bought at firesale prices (high margin of safety and long-term valuation return boost) – average holding is 32% undervalued

Essentially I’m a dividend-focused contrarian value investors. That means always looking for the best opportunities in terms of generous, safe, and growing yield, that, for short-term reasons, Wall Street hates. The key to this strategy is to avoid “yield traps” or stocks with mouth-watering but unsafe dividends that are likely to be cut and thus send the share price crashing.

Fortunately Wall Street is famous for overreacting to a company’s short-term challenges, and thus there are usually plenty of great high-yield, deep value opportunities for long-term income investors to profit from. Let’s take a look at why Kite Realty Group (KRG) is one of my strongest conviction buys right now. Not just do I own it myself, but during the most recent market downturn, it was one of just 11 stocks I was buying for my portfolio.

Today Kite Realty represents one of the best, but little known, high-yield dividend growth stocks you can buy. One that offers not just a low-risk 7.9% yield and solid long-term dividend growth potential, but is likely to generate close to 18% annualized total returns over the next decade. That’s about double the market’s historical CAGR total return of 9.2%, and potentially makes Kite not just one of the best high-yield stocks you can own in the future, but one of the best investments of the next few years, period.

Why I Own Kite Realty And You Might Want To As Well

Kite Realty was founded in 1997 but IPOd in 2004. The REIT owns 115 community retail centers in 19 states. Note that KRG is NOT a mall REIT, with significant exposure to struggling or bankrupt retailers like Sears. Rather Kite’s centers are mostly focused in large, rich, and fast-growing cities. In fact, 75% of its rent comes from these primary core markets.

(Source: investor presentation)

Similarly, its retailers are not the slow-moving dinosaurs who are going bankrupt these days. 93% of its rent is from retailers who are naturally e-commerce resistant (like restaurants or gyms) or have adapted online sales into their own operations (omnichannel success stories like Walmart, Target, Lowe’s, and TJ Maxx).

(Source: investor presentation)

The REIT is also highly diversified, with even its top 10 tenants making up less than 20% of annual rent, and most of that from thriving retailers.

(Source: investor presentation)

Today 70% of new leases are signed with restaurants, service providers (like gyms), and other e-commerce resistant businesses. Combined Kite’s long-term leases with these retailers provide it with very stable cash flow (what REITs calls FFO or funds from operation) to pay its dividend, which currently yields a mouthwatering 7.9%. But a safe 7.9% yield is just one reason I bought this stock so aggressively during the worst month for stocks in 7 years.

Why Wall Street Hates The Stock But Why This Safe 7.9% Yielding REIT Could Make You A Fortune

Since mid-2016 Kite Realty is down a staggering 47% from its all-time high. Why has Wall Street hated this stock for over two years? Well REITs, in general, are in a bear market since long-term interest rates (10 year-yield) has risen from its all-time lows (which put REITs in a bubble).

Add to that the fact that the market’s obsession with the “retail apocalypse” has soured investors on retail REITs in general, and you get a badly beaten down share price. However, there’s one more reason Kite is so unloved right now.

That would be because in 2017 management, led by 21 year company veteran John Kite (CEO since 1997, before it IPOd), initiated a three-year company restructuring plan. This called for about $255 million in asset sales (dispositions).

(Source: investor presentation)

$155 million of those asset sales are now complete, with the REIT selling off (at a healthy profit) its lowest quality centers. Those located in secondary markets with less population density, lower average household incomes, and that generated 42% less average base rent per square foot.

Selling income producing assets means that Kite’s FFO/share decreased 1% in 2017 and management expects it to fall 2% in 2018. In 2019 the final $100 million in asset sales are expected to cause one final 2% FFO/share decline. Wall Street HATES negative growth, especially for three years. So if Kite is technically facing declining cash flow (dividend continues to rise, however), then why do I own it and recommend it? Because of what management is using the money for.

(Source: investor presentation)

First, the REIT is paying down debt. In 2011 Kite’s net debt/EBITDA (net leverage ratio) peaked at 13.3, a dangerous level. High debt is what caused this REIT, as well as 56 others, to have to cut or eliminate their dividends during the Financial Crisis. Despite cash flow covering their payouts, credit markets slamming shut required most REITs to retain more cash, in case the credit crisis lasted for years. The entire industry has spent the last 10 years deleveraging (despite record low borrowing costs), and today the REIT sector’s debt/capital ratio is 30%, the lowest in its history (REITs were created by Congress in 1960).

Few REITs have deleveraged as aggressively as Kite, whose current leverage ratio is 6.7, down 50% from its dangerous peak seven years ago. That ratio is headed to 6.5 by the end of the year and management has said that further paying down debt is a top priority in 2019, when it completes its asset sales. Most likely that will mean Kite’s net leverage ratio falls to 5.9 to 6.1.

But even better than shoring up the balance sheet is Kite’s “3-R” investment strategy.

(Source: investor presentation)

The REIT is now self-funding, meaning using just its retained cash flow (FFO minus dividends = $65 million per year), plus asset sale proceeds to redevelop and improve its properties. That means not just nicer stores and centers, but also building out hotels and apartment buildings as well. These “mixed-use” properties are extra valuable since they drive higher traffic that benefits retailers via greater sales per square foot. That allows Kite to then raise rents when leases expire. In total Kite plans to spend about $121 million on these renovations in the next few years, generating between 8.1% and 11% returns on investment. That will grow cash flow by about 7% and help it to keep growing the dividend safely.

The REIT’s lease spread (how much it raises rents on new leases) is current 7.3% and 11.4% when you factor in annual rental increases built into the contracts. Double-digit lease spreads are a good proxy for quality properties that will attract and retain thriving tenants and thus generate steady and recurring cash flow to fund the dividend.

Better properties also mean higher occupancy and stronger lease spreads help to drive organic growth (what REITs call same-store net operating income or SS NOI).  Yield trap REITs, with failing business models, show negative lease spreads, falling occupancy (which is typically under 90%), and negative SS NOI. On the other hand, Kite’s fundamentals are strong and moving in the right direction. For example, the occupancy rate is 93.9%, a healthy level. That’s down 0.5% in the past year mostly due to the Toys “R” Us bankruptcy. However, 40% of the space leased to that bankrupt retailer has already been re-leased, and at much higher rents. Thus this minor dip in occupancy is likely temporary. Meanwhile, SS NOI is up 1.5% for the year, and average base rent is up 5% YOY. These strong same-store fundamentals show that Kite’s business model isn’t dying, but improving, despite what the share price might lead you to believe.

But ultimately REITs are owned for their generous and growing dividends. Kite’s dividend profile is among the best in all of REITdom. That’s courtesy of a nearly 8% yield (four times that of the market) that’s low-risk. That’s due to the 64% payout ratio which is far below the industry average.

• Yield: 7.9% (vs 1.9% for S&P 500)
• FFO Payout Ratio: 64% (industry average 80%)
• 10 Year Analyst Consensus For FFO/Share (and Dividend) Growth: 4.3%
• Total Return Potential (From Fair Value): 12.2% (vs 8.3% for S&P 500)
• Valuation Adjusted 10 Year CAGR Total Return Potential: 17.8% (vs 0% to 5% for S&P 500)

And while true that the REIT’s leverage ratio of 6.7 is higher than the average REIT’s 5.8, the interest coverage ratio of 3.5 is still safely in line with the sector average (3.4). That’s why Kite has a BBB- (investment grade and stable) credit rating that lets it borrow at 4.1% (89% long-term fixed-rate bonds). 4.1% borrowing costs are less than half the returns on capital its investments are generating, showing that Kite is able to grow profitably. In fact, thanks to its high retained cash flow (low payout ratio) even after asset sales are finished in 2019 the REIT will still be able to fund all growth with retained FFO alone. Management expects that positive FFO growth will return in the second half of 2019 and by 2020 the REIT will be growing at its historical rate.

That means that in addition to a safe 7.9% yield, investors can expect long-term dividend growth of about 4% as well. Factor in multiple expansion and that translates into a nearly 18% CAGR total return over the next decade. That’s double the market’s historical return and makes Kite Realty a potential retirement maker.

Why is Kite likely to generate such amazing returns? That would be one of the lowest valuations in the sector. There are many ways to value a stock but for REITs, two are most useful. The first is to look at the Price/FFO ratio, which is the REIT equivalent of a PE ratio.  

• Price/FFO: 8.1 (sector average about 16.5)
• 13 Year Average P/FFO: 12.4
• FFO/Share Growth Rate Baked Into Current Price: -0.2% (4.3% actually likely)

Today Kite trades at half the sector average, and 35% below its 13 year average (since IPO). That means that today’s price is baking in 10 years of -0.2% annual FFO/share growth. In reality management, analysts, and I, expect 4.3% growth. With such a low bar to clear, if Kite can grow at all then its P/FFO ratio will rise, its yield will fall, and investors will enjoy a very strong valuation boost. How strong? Well, that’s where the most useful dividend stock valuation method comes in. That would be dividend yield theory or DYT.

Since 1966 asset manager/newsletter publisher Investment Quality Trends has been exclusively using this valuation approach to generate decades of market-beating returns (with 10% lower volatility to boot).

(Source: Investment Quality Trends)

DYT simply says that for stable businesses like REITs and most dividend stocks (growth rates are stable over time), yields are mean reverting. This means they cycle around a relatively fixed point that approximates fair value. A stock that normally yields 4% over time that is now yielding 5% is 20% undervalued ((5%-4%)/5%). Or to put another way, such as stock would need to rise 25% (upside to fair value yield) in order to return to its historical norm. As long as the fundamentals don’t break (business model deteriorates) nearly all dividend stocks eventually (usually within a few years) return to their fair value yield. This means that share prices rise faster than cash flow and dividends, boosting your total return to: yield + cash flow/dividend growth rate + valuation boost (annualized over how long it takes to get back to fair value).

This is called the valuation-adjusted Gordon Dividend Growth model and has been relatively accurate in predicting dividend stock total returns since 1966 (52 years).  

• Yield: 7.9%
• 5 Year Average Yield: 4.3%
• 13 Year Median Yield: 4.8%
• Estimated Fair Value Yield: 4.6%
• Discount To Fair Value: 42%
• Upside To Fair Value: 72%
• 10 Year CAGR Valuation Boost: 5.6%
• Long-Term CAGR Total Return Expected: 7.9% Yield + 4.3% FFO/Dividend Growth + 5.6% valuation boost = 17.8%

Thanks to the perfect storm of short-term negative factors Kite’s yield is 72% above its fair value yield. I find that by taking the midpoint of its five-year average and 13-year median yield.

This allows us to estimate what the yield returns to if the turnaround is successful and the market stops hating the stock (market can’t ignore strong and rising fundamentals forever). This means that Kite is about 42% undervalued today, and the share price can be expected to outpace FFO/share and dividend growth by 72% over time. I can’t tell you how long that will take, but it’s almost certain to happen within the next five years. For my return model, I use 10 years. Even over this prolonged period, that means that Kite shares will likely outpace cash flow and dividend growth by 5.6% on an annualized basis. Combine that with the current yield and that’s how you get to an expected CAGR total return of nearly 18% over the next decade. Or to put another way, buying Kite today means that by the end of 2028 you could be looking at a 415% total return. All while enjoying market-beating returns from its generous dividends alone (S&P 500 is likely to deliver far less than 8% CAGR total returns over the next 10 years according to Morningstar, BlackRock, and Vanguard).

But as great a high-yield dividend growth investment as Kite is today, that’s only if you’re comfortable with the risk profile.

Risks To Keep In Mind

There are several risks potential Kite investors need to be aware of before buying this stock. First, is the fact that this small REIT, while possessing strong fundaments, is NOT yet a blue chip. Specifially, to attain the famous sleep well at night or SWAN status (in which dividend cuts even during very severe recessions are unlikely) it will have to continue deleveraging its balance sheet.

That’s because while a 6.0 net leverage ratio would be safe in the long-term, in order to obtain higher credit ratings (to BBB and BBB+), and the lower long-term borrowing costs that go with that, will require Kite to continue self-funding its 3-R strategy for several years. The good news is that the REIT’s retained cash flow is sufficient to cover 100% of investments and thus it could avoid taking on new debt (other than refinancing existing bonds and credit facilities). The rising cash flow would then lower its leverage over time, and make the overall balance sheet (and dividend) even safer in the coming years.

However, thus far management has only said it is committed to paying off debt through 2019 when it will complete the last of its asset sales. Thus I’ll be watching closely in 2020 and beyond to see what kind of capital allocation decisions management makes. Theoretically, the REIT might take on additional debt in order to acquire new properties or even make an acquisition of a smaller REIT. Such M&A activity always comes with execution risk, including possibly overpaying for an asset and increasing the leverage ratio headed into a future recession.

Speaking of recessions, here there’s good and bad news. The good news is that the current payout ratio and debt levels mean that, barring an even worst Financial Crisis than last time, Kite isn’t likely to cut its dividend in the next economic downturn. BUT while 93% of its tenants are e-commerce resistant, not nearly as many are recession proof. While it does have plenty of strong defensive anchor tenants (like Walmart, Target, dollar stores, and discount retailers), many of its tenants might see their business decline when the economy next shrinks. That will likely mean that FFO/share once more turns negative, which Wall Street will likely punish with a sharply lower price.

What’s more, while the dividend is likely to be maintained (I wouldn’t own it if I weren’t highly confident of this), it may be frozen for the duration of the recession. That would further weigh on the share price. Of course, in that scenario (where KRG’s yield soars to 10+%) I’ll be adding more by the bucket full. But investors who are very uncomfortable with such volatility need to keep this in mind and size their positions accordingly.

Finally, due to its still relatively large exposure to secondary (smaller, less dense, and less affluent) markets, Kite’s lease spreads remain weaker than rivals like Brixmor (BRX) and Kimco (KIM), both of which I also own. Remember that lease spreads are a proxy for the quality of a retail REIT’s asset base. Should KRG’s lease spreads fall below 10% for a long period of time that would call into question management’s current 3-R strategy. And of course, those lease spreads will naturally decline during a recession. That’s why it’s good that the final $100 million in property dispositions should greatly boost this REIT’s property quality and allow it much higher lease spreads, at least in theory. But investors will want to make sure that this important metric actually goes up (it’s found in the earnings releases) in the coming quarters.

Bottom Line: At Today’s Price Kite Realty Is One Of The Best High-Yield Investments You Can Make

Don’t get me wrong, Kite Realty, like all stocks, faces its fair share of challenges and is not a risk-free investment. But the current fundamentals mean that its 7.9% yield is likely safe, even during the next recession (why I own it in my portfolio). Meanwhile, management’s plan to self-fund a large number of highly lucrative property improvement projects is likely to lead to strong cash flow and dividend growth in 2020 and beyond.

When you combined Kite’s nearly 8% yield, with its 4% long-term growth potential, and then add in shares trading at a 42% discount to fair value? Well, you get the potential for not just generous, safe, and steadily rising income, but likely about 18% long-term CAGR total returns as well. That’s not just a fantastic return (and likely to beat the market by three or even four times in the coming years), but makes this little known, and highly unloved REIT one of the best investments you can make at this time.

That’s as long as you are patient enough to wait for the turnaround to succeed, are comfortable with the risk profile, and have a long enough time horizon (5+ years).

Some companies that posted stellar earnings reports, saw their shares tumble during October’s broad market sell-off.  This has created an exceptional buying opportunity to get involved in some high growth stocks “on the cheap.”

And if you use call options, rather than buying the underlying shares, you will not only be deploying your capital in a more efficient manner but get the benefit of higher leverage, which could mean bigger gains.

This a pretty unique opportunity, in that over the past few years companies that reported better than expected results were quickly rewarded with a move higher in their stock price.

But the confluence of rising rates, tariff issues, and the looming mid-term election, had investors taking a much more cautious approach.

Basically, after years of gains, the reaction was to sell now, ask questions later.

According to Factset, with nearly 70% of the S&P 500 companies having already reported earnings results, nearly three-quarters have posted numbers beating expectations.  And around 50% have either raised or maintained guidance. In the past, numbers like these would have given shares a boost, sometimes an irrationally large one.

But this quarter, the reactions to those “beats” have been met with selling, which is telling us something about investor psychology right now.

Factset data shows over the prior 8 quarters, that the typical post-earnings beat reaction is that the stock in question rises 1% on average that day. During this quarter, the average reaction has been a drop of 1.5%.

I think this presents some great opportunities.

Source: FactSet

Last week I discussed how GrubHub was good buy near $87 per share and is now some $8 higher at $95.

Here are 3 more names that could be scooped up cheap in the wake of unwarranted post earnings declines.

1. GoDaddy (GDDY) shares dropped over 5% following their earnings report, despite the fact it delivered a ‘triple play’ – it beat on top and bottom line and raised guidance.  For good measure, it also boosted the share buyback plan to $500mm over the next 12 months.

The stock has now dropped to major support near the $65-$68 level, providing a great risk/reward entry point.

Source: StockCharts.com

2.  Match.com (MTCH) controls online dating apps, such as, Match, Tinder, OK Cupid, Plenty of Fish, OurTime and Pairs.  It pretty much owns the space and it, in turn, is majority owned by IAC Interactive (IAC).

The stock had sold-off in May when Facebook announced it may offer an online dating tool.

Shares gapped up following last quarter’s report and it has now pulled back towards that $50 level.

Last night it posted better than expected top and bottom line and maintained guidance of 25% growth through the next fiscal year.

Yet investors chose to throw a “glass of wine” in the company’s face and sell.

With shares down roughly18%, and near support of the $40-$43 level, an investor could buy some longer dated calls in anticipation of a move higher.

3. Apple (AAPL) really needs no introduction.  The company beat on nearly every metric but investors got worried when the company said it would no longer report unit sales of phones and tablets.

Then shares did a double dip the following day on news it was not increasing production for the iPhone XR.  However, AAPL said in their conference call that this was previously known.

After a brief dip below $200, the stock has reclaimed that level and it looks ready to move higher and become a $1 trillion company again. (To do that it would need to trade above $213 per share)

 For these 3 stocks and others, traders could use this momentary stock price displacement, caused by this reaction to earnings, to get long good companies on big dips. And consider using longer-dated call options, which can give you leverage and be an efficient use of capital.

Well, you survived it. Months of campaign ads, haranguing, debating, and general buffoonery are finally over. Now we get back to the real business of our elected leaders – vying for 10-second spots on the evening news, suing each other, and trying to buy your vote with your kids’ money.

For gold, in the near term, the effect seems to be nothing. New York morning gold is down 3 USD, not quite rounding error against a price of 1230. Time will tell if our prediction yesterday will come true, but so far so good.

Source: Shutterstock.com

Here at the Gold Enthusiast, we believe the two primary drivers of gold price are the value of the local currency and geopolitical events. Does the morning news say anything applicable about those two? Turns out the answer is Yes.

On the US Dollar front, the Dollar appears to be losing ground post-election. Most probably that’s due to investors thinking that 2 more years of basic gridlock in Washington DC will mean difficult times ahead for pro-business policies. And they’re probably right.

The other side of the belief that the USD will decline is the knowledge that USD is valued against currencies of other countries – which can be MUCH more unstable than the good ol’ USA.  It’s the net result that’s important, and it’s too early to tell how that will work out. In your friendly Gold Enthusiast’s eyes, of course. You are welcome to have a different opinion.

Because even though US elections change who’s butt is in the chair, they’re still sitting in the same chairs. “Changing government” means revolution or restructuring, which the US hasn’t done in over 200 years. After US elections the new butts are still restricted by the same laws, and while they may try to go around those laws it’s the stability of the laws that really matter.

So while some try to pre-judge the effects (such as here and here), we’re content to wait a little while and see what the market does. Very seldom does the initial reaction dictate the final direction in the trading world – because there’s always another factor around the corner, a different black swan getting ready to fly.

Signed,

The Gold Enthusiast

Every election season the media loves to plaster bold headlines about how stocks in general, or some companies in particular, will soar or plummet if one candidate or party wins or loses. Such articles and arguments usually make a great deal of sense, at least superficially. However, market history is littered with examples of investors losing big because they mixed their political beliefs with investing decisions.

In fact, no less than Warren Buffett, the greatest investor in history has said “if you mix your politics with investing decisions you’re making a big mistake”. Let’s see why the Oracle of Omaha is absolutely right, and why making large portfolio shifts based on expected election outcomes can end up costing you a fortune.

Politically Motivated Investing Decisions Can Cost You A Fortune

Perhaps the most famous prediction about election effects on the stock market came from Nobel Prize-winning economist Paul Krugman on election night 2016. Based on various polls in the run-up to the election, most political prediction models gave Trump no more than a 35% chance, at best, of winning the Presidential election. When actual results starting coming in that showed he would become the next president stock futures plunged, with the Dow futures hitting -1,000 at one point. That pointed to a 4% decline at the open the next day. Due to his earlier predictions that Trump’s policies would trigger a global recession Krugman told reporters:

“It really does look like ‘President Donald Trump’ and markets are plunging. If the question is when markets will recover, a first-pass answer is ‘never.”

In reality, the US and the global economy did NOT fall into recession, and the S&P 500 has gone on to deliver 33.5% total returns since Trump’s surprise election win. That’s despite 2018’s correction and the recent pullback in October (the worst month for stocks in seven years).

But that’s just one example of many. For example, when President Obama won in 2008 many predicted that renewable energy (solar and wind) companies would boom.

Between Obama’s election in 2008 and his re-election in 2012, the Invesco solar ETF declined by nearly 90%. To this day investors are sitting on massive losses.

That’s despite the solar industry, in fact, booming, just as pundits said it would. How can that be? How can the industry itself grow like a weed yet solar company shares plunge? Because the “Obama is good for solar stocks” argument is extremely simple and fails to take into account the fact that share prices are ultimately based on fundamentals. Specifically that while demand for solar projects would go up, oversupply (especially from low-cost Chinese panel makers) would drive down panel prices to the point that many solar companies would go bankrupt. In fact, it’s precise because solar companies overdid it on capacity (ahead of expected demand) that solar prices fell fast and far enough to help spur that impressive growth in solar project installations. Any investor who failed to remember the law of supply and demand, or that, in the long-term, share prices are always a function of earnings and cash flow, lost their shirt.

Similarly, anyone who was so passionately against Trump that they let fears of a coming recession (and bear market) keep them on the sidelines, has today missed out on substantial gains.

Since 1926 stocks have finished higher for the year 74% of the time. And over rolling five and 15 year periods investors have seen positive total returns 86% and 100% of the time, respectively.

Over the past 92 years, there have been 23 Presidential elections and 46 midterm elections. Stocks have gone up most of the time because ultimately they don’t care about who wins elections, but whether or not the economy and earnings are growing. Yes, different parties can put in place policies that can slow or accelerate growth, at least in the short-term. But ultimately anyone who bets against America’s continued long-term secular growth has lost out on spectacularly.

Perhaps Warren Buffett said it best when he told CNBC “50% of the time the President I voted for lost. It’s never kept me out of stocks”. The lesson for investors is clear, don’t mix your personal political beliefs/fears with your long-term investing decisions. If you do, you’ll probably regret it.

But what about this midterm election? Surely it was the GOP corporate tax cuts that helped drive the market’s impressive rally since November 2016 right? So if the Democrats win in either House might not that threaten the pro-stock policies that Trump and Republicans put in place? Again, that sounds like a plausible risk, and some might feel tempted to sell before the election ahead of a possible market plunge. But once again, history shows that anyone doing so will probably be making a costly mistake.

Historically, No Matter Who Wins Midterm Elections Stocks Have Always Gone Up, By A LOT

Many investors believe that it was uncertainty about the coming midterms that at least partially caused stocks to crash in October. However, while that might have been a small part of the reason for the most recent pullback (S&P 500 didn’t even enter a correction), anyone selling before election day is likely making a big mistake.

That’s because since 1950 the stock market has usually been negative in October, only to rally about 9% through the end of the year, usually around the time the election ends. But those are just averages, surely some midterm elections see stocks plunge right? Actually no. Since 1946 there have been 18 midterm elections, and 100% of the time over this 72 year period, no matter the outcome, stocks were up 12 months later. Even more impressive? On average stocks gained 17% in the year following a midterm. That’s because the post-midterm rally doesn’t just apply to the year of the election itself. Usually, the year following is the strongest one for the market, in terms of the four-year cycle.

This means that, if market history repeats itself, then 2019 might see stocks rally about 14%. And keep in mind that the above chart goes all the way back to 1928, and thus includes the Great Depression when stocks fell 90% at one point. That skews the average much lower.

Since 1946 the average market gain, from that year’s lows (usually before the election) to the end of the following year (2019 in our case) was 32%. This means that if you fear a negative outcome on election day enough to be out of stocks you risk missing out on VERY substantial gains.

But that’s the average gain, which might be inflated by especially bullish years right? Indeed that’s true. But according to Ned Davis Research since 1946 not just has every single midterm been followed by a rally, but the median gains for stocks (half above and half below this amount) has been 18.4% in the 9 month period from September 30th to June 30th.

Why is that?

Well most likely because over the past 21 midterms the President’s party has, on average, lost 30 seats in the House and four in the Senate. In just 2 midterms did the President’s party gain seats in both houses of Congress.

What that means is that typically midterm elections bring a switch in party control to at least one chamber and gridlock. You might think gridlock is bad for stocks, but in fact it actually helps companies. That’s because when we have a split government then no major or radical policy changes are typically possible. The status quo remains intact (today that means less regulation and lower corporate taxes) and companies can better plan their long-term investing decisions.

What about 2018? Well according to fivethirtyeight.com, the most accurate election forecaster of the past decade, here’s how the final probability of this year’s elections stands, as of election day itself:

• Probability of GOP losing the House: 81.1%
• Probability of Democrats winning the Senate: 18.9%

These probabilities have been pretty stable for the past few months, meaning that, barring some shocking outcome Tuesday night, the stock market has already priced in gridlock in Congress. Remember that it takes control of both Houses, AND the White House to get major policy changes done in today’s hyper-partisan political climate. If the Democrats win the House they can PROPOSE anything they like, including corporate tax increases to 90% if it so tickles their fancy. It would NOT pass the Senate and even if it did Trump would veto it. It would then require a ⅔ vote in BOTH Houses to override that Presidential Veto. Thus the risk of corporate taxes going up in 2019 is effectively zero.

What about increased regulations? Well, Trump has been reducing regulations at a record-breaking clip, via executive order. That means he doesn’t need either chamber of Congress to sign off on it. But what about a Democratic House impeaching Trump? Sure the House can do that. BUT it takes 67 votes in the Senate to remove a president. Thus even that scenario is extremely unlikely. The worst that might happen is that the Democratic House, frustrated at not being able to get anything into law, might impeach Trump just to put him through the political circus that would entail.

But while that would be a major political distraction that would unfold over years, that scenario would similarly not change anything substantive for corporate planning purposes. And don’t forget that on August 22nd Pelosi (the minority leader in the House right now) said that impeaching Trump was “not a priority”.

Basically, this means that the most likely outcome of the 2018 midterms is, as usual, gridlock in Congress. Which means that most likely stocks will rally over the next year, and finish both 2018 and 2019 with solid gains. Anyone who makes the mistake of getting out of the market due to political fears is likely to deeply regret that decision.

Bottom Line: No Matter Who Wins Elections, The Stock Market Always Ultimately Responds To Fundamentals

During election season the media loves trotting out headlines about the “best stock to buy if X or Y wins”. And similarly, you might see lots of sensationalistic pronouncements about how if the Democrats or Republicans win then the economy and stocks will tank. But remember that ultimately stock prices are based on the fundamentals, meaning earnings, cash flow, and dividends.

Companies have management teams whose job it is to adapt and overcome any challenges that might come from major policy shifts in Washington. In fact, despite what the DC beltway may think, Washington’s role in the economy is far smaller and less important than most politicos think. That’s why the market has risen in 74% of years, no matter which party was in charge of the White House and Congress.

And as for this year’s midterms? Well while it’s almost certain that the GOP will lose the House, remember that Gridlock is usually how these elections turn out. And as 18 consecutive post-midterm rallies have shown, it ultimately matters little to stocks what party does or doesn’t win.

The best thing investors can do is remember that their portfolios are a business (holding company of other companies). That means your capital allocation (investing) decisions should always be made with a clear mind and with an eye on meeting your long-term goals; independent of politics. The US and the global economy are far more complicated than most political pundits can fathom and thus the outcome of any election is usually NOT going to result in the kind of stock market moves they often expect.

It’s finally here — Election Day 2018.  Midterm elections for President Donald Trump’s first term in office  (just in case he gets re-elected).

Seems every election now is “the most important election of your life.”  Ten years ago, people were saying that because it was the first time a black man had a real chance of becoming President of These United States, which Barack Obama did become.  After soundly defeating political insider Hillary Clinton in the primaries.

Then 2012 was “most important” because those darn conservatives were threatening Barack’s reign in the White House.  President Obama won re-election but the Democrats lost the majority in the House but kept the Senate. Oh no, now the Democrats will have to actually negotiate with the other side rather than just get their way.  Which they hadn’t been able to do even while holding a Supermajority card if everyone just voted party lines.  Which shows just how difficult real leadership is, and how little of it the Democrats actually had.
Then two years ago some second-rate television “star” somehow pulled off the upset of the century.

The apparently undefeatable Democrat machine behind – once again – Hillary Clinton managed to lose an election against a political first-timer.  Donald Trump had even had trouble garnering the support of the Republican party, what with him being the outsider candidate.  But unlike Bernie Sanders, Trump was able to pull together a message that resonated across his side of the political spectrum, even stealing some critical votes from the Democratic side of the aisle.  Whoda thunk it.

Now, this election is “most important” because, well, all the usual reasons.  Only louder this time.  Except that the economy is actually doing relatively well (according to the Federal Reserve at least) and there really are masses of people marching toward the US border. A large number of incumbents have decided to call it quits for some reason, leaving behind jobs most people would LOVE to have – guaranteed free travel, high pay, high prestige, and income for life in some cases.  Seems you just can’t please some people.
What will the likely effect be on our favorite yellow metal?

Well, in your Gold Enthusiast’s memory, US elections have done little to affect the current trend of gold (GLD) prices. Possibly because the US is seen as relatively stable compared to most countries, with a form of government that guarantees change will be difficult and encouraging to people who keep getting up in the morning and going to work.  Yes, the election will probably affect the price of gold in the short term.  If the Republicans don’t lose too much ground in the US House and US Senate, we’ll end up right back where we were yesterday, and the struggle will continue.  No change means no change, after all.

If the Democrats take significant control of the House or Senate, the fight will be on.  The US will become less stable and less able to project a clear voice to the rest of the world.  There are countries out there who would appreciate an easy opportunity to grow in stature (I’m looking at you, China and Russia). Such an outcome would likely be positive for the price of gold, although probably not by much in the short term.  Rather it would probably be another support under gold prices, nudging them back up toward resistance at 1245.

Whatever happens, let’s all keep in mind that the worst possible outcome would be a deeply divided United States that loses the ability to work together to (a)run a world-leading country, and (b)compromise to solve real problems.  Such as an out-of-control deficit, declining middle class, and starving children.

Make the time to vote today.  Your vote is important.  And as the wise man said, If you don’t vote you can’t bitch.

Tuesday’s election is being viewed as possibly the most impactful mid-term vote in decades.  Many consider its referendum on the direction that the U.S. will take social, economic and foreign policy issues.

The stock market seems to be bracing for results — much like the way that investors await earnings releases for specific companies.

I think we can set up a trade to profit from the election as we would from an earnings report.

Indeed, if we look back on prior pivotal votes such as Brexit, and the last presidential election, we can see that the options market behaved similarly to an earnings release; implied volatility rose dramatically heading into the events and then dropped following the results.

We now have two pieces of the puzzle; we expect a decline in implied volatility and for the market to move higher in coming weeks.

A strategy that would benefit from such a scenario is a ratio call spread which consists of buying near-the-money calls and selling a greater number of further out-of-the-money calls.

An example would be, using the SPDR 500 Trust, that one could buy one December 273 call for around $7.50 per contract, then sell 3 contracts of the December 285 calls for what would cost around $2.00 per contract.

The total net debit of the contract position would be $1.50 or $150 per 1×3 contract spreads. The potential profit is $10.50, or 700%, if shares are at the 285 strike on the December 21st expiration.

Now go out and vote!

The stock market has entered a higher volatility environment; what does that really mean, and how can you profit and protect your portfolio?

What sometimes gets lost in the broad discussion of VIX, and general market volatility levels, is the specifics of how implied volatility gets factored into individual option prices and impacts position profitability.

Implied volatility is one of the most important concepts when trading options. In this article, we’ll try to understand a little bit more why it is important and how to use it when trading to increase our profits. With volatility on the rise, this a good time to review some basic concepts surrounding it, both real and implied.

IV is the Answer

What do former NBA star Allen Iverson and implied volatility have in common?

They have both been labeled “The Answer.” While Iverson has been more of a question lately (on how he spent his $100 million+?)

Implied volatility remains the key to answering the number one question on an options trader’s mind:

Is this option “cheap,” or “expensive”?

Implied volatility is a “plug number” (a placeholder number used to make a calculation estimate correct) — used to make the result from the commonly-used apparatus for valuing options, the Black-Scholes model. It considers 5 factors in calculating a particular option’s theoretical fair value:

1. The price of the underlying security

2. The strike price

3. The time, or expiration date of the option

4. Interest rates * this is becoming increasingly important in the rising rate environment and with upcoming FOMC meetings.

5. Implied volatility

The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us “theoretical” implied volatility, which helps us decide if an option is cheap or expensive.

But given that options trade regularly, there is already an “actual” implied volatility assigned to each option, based on its price, which is constantly updating in real-time. Therefore, our mission — should we choose to accept it — is to determine whether an option’s current price looks cheap, or expensive based on its volatility level.

High or Low? Depends?

IV has a major impact on trading. To simplify this idea, let’s look at an example:

Stock A is priced at $100 and has high implied volatility. Let’s say that the call strike 100 costs $4.

Stock B is also priced at $100 but has low implied volatility. Let’s say that the call strike 100 costs $1.

When comparing the two trades, we can see that the break-even point of stock A is $104 and for stock B is $101. This means that we have a 1% increase to show profit in stock B, but 4% in stock A. Furthermore, if we assume a similar increase, let’s say 5% in each stock (by expiration) — we can see that there’s a $1 profit in stock A, but a $4 profit in stock B.

The following Table summarizes the two scenarios:

Compare high and low implied volatility scenarios.

To put it simply: When IV is low, it’s easier to profit and your profits are higher (for buyers). When IV is high, it is harder to profit — and the profit is lower. Of course, it is visa-versa for option sellers.

Sometimes, however, higher IV is justified, mainly due to stock volatility/conditions or market conditions. For example: NFLX volatility is twice as high to WMT (when compared in percentage). We can also expect the IV and the options premium to reflect that.

An analogy could be done to the PE ratio. Most of the time, a company deserves a high or low PE ratio. But when it’s extreme, it is usually a contrarian sign.

So, how do we know if IV is high or low? AND more importantly: How do we know if the odds are in our favor?  By using IV Percentile (Rank)

IV Rank (percentile) is a measurement of stock IV. For example, if a stock has a IV Rank of 92.5%. This means that over the last 200 days, 92.5% of them had lower IV than the current one. Or simply put: The current IV is high.

These calculations have several characteristics:

• There is fluctuation between 0-100
• Reverting (after a high value, you can expect a lower value in higher probability)
• If the IV rank is high, it is more favorable towards options selling.
• If the IV rank is low, it is more favorable towards options buying.

Right now, we are in an interesting place; volatility, both real and implied, are trending higher. But, still well below peaks or panic levels, despite the relatively high level of overall uncertainty.

With elections, trade tariff talks, and crucial Fed meetings regarding interest rates, expect an increase in both realized and implied volatility levels. Knowing this will impact your positions., and help them become more profitable.

After a very rough month, stocks have enjoyed a nice rebound. But there are several indicators that say the worst might not be over.

The major stock indices lost, on average 7%, during October — the worst monthly performance since 2016.

And that decline was pared significantly by a 3.6% rally in the last two days of the month. It continued on this first day of November. This has many people thinking that they’ve seen the near-term low. But, looking at the bigger picture suggests that the bear market may come back to bite again.

First, there is strong historical data that shows that the last two days of October — and the first two days of November — are the best performing days annually, gaining 1.2% over a four-day period.

The market more than doubled those average gains. But they tended to be short-lived.  That’s because the rally’s main driver is that most money managers, pensions, and mutual funds tend to end their fiscal year on October 31st.

As they close their books, they tend to not only rebalance their positions, which help lift prior underperforming sectors, but also tend to put any excess cash to work.

Indeed, the bounce has been most pronounced in beaten down areas. Here is the semiconductor index getting a huge 7.8% rally in the past few days.  Note: It’s heading right into major resistance:

Likewise, the Home Construction Index has enjoyed a 5.6% rally but may run into trouble at the $33 level.

Looking at the broader market, we can see the S&P 500 held an important level at $260 and has had a good bounce.  But unlike prior declines, it not only broke the 200-day moving average but also remained below it. Unless it can clear the $275 level, the downtrend and bears will remain in control.

As we turn toward the Nasdaq 100, which is dominated the FANG stocks like Apple, Amazon, and Google and has led the bull market, we also see a break of the 200 DMA as well as important trendlines.

Things look even worse as we zoom out of the monthly chart, which now has a bearish candle breaking a multi-year trendline.

So, don’t let the recent action fool you into thinking the worst is over.  Remember, the biggest stock market rallies come in bear markets. You don’t get 7% snap back rallies during up-trending bull markets.

It takes high volatility to spark something like that, and it only happens when risk is extremely elevated.  The current rally is not characteristic of the type of environment where stocks are going up

Note, the top 10 largest up days over the past 30 years took place in 1987, 2002, 2008 & 2009.   Those were all in the teeth of major bear markets.

The epic fall of General Electric (GE) is one of the most severe cases of shareholder wealth destruction in corporate American history. Once worth over $600 billion this bluest of blue chips (and a dividend aristocrat to boot) is now worth just $88 billion. That means GE has erased over $500 billion worth of value, a figure that’s greater than Facebook (FB) is worth today.

Let’s look at three essential lessons the collapse of this venerable blue chip should teach all investors about protecting their hard earned wealth.

The Wheels Can Fall Of The Bluest Of Blue Chips

GE is 126 years old and has been paying uninterrupted dividends for 119 straight years. They are one of the most storied companies of all time, having been co-founded by Thomas Edison and JPMorgan. And up until it cut its dividend during the Financial Crisis GE was a fabled dividend aristocrat (S&P 500 companies with at least 25 straight years of dividend growth).

But even aristocrats, the bluest of blue chip dividend stocks, can fall from grace. Here are the former aristocrats who have cut (sometimes to zero) their dividends over the past decade.

Bank of America
Avery Dennison
BB&T
Comerica
Centurylink
First Horizon
Gannett
General Electric
KeyCorp
Pfizer
Regions Financial
Synovus Financial
State Street
US Bancorp.
Progressive Corp
SLM Corp
Supervalu

And three more former aristocrats lost their status, thanks to freezing their dividends for longer than seven quarters (the maximum allowed to remain an aristocrat and achieve positive YOY annual dividend growth).

Johnson Controls
Eli Lilly
M&T Bank

Heck, Sears (though never an aristocrat) was once the Amazon of its day and the largest retailer on earth. That bankruptcy (and likely future liquidation) also has three important lessons to teach investors.

The point is that with all companies, even blue chips, you need to adopt a Reagan-like the mentality of “trust but verify.”

No Dividend Is Ever Truly “Safe,” Just Low Risk

After a disastrous third quarter, GE’s new CEO (second since 2017) announced the company was slashing its dividend, for the second time in a year. A staggering 92% cut follows the 50% earlier one, meaning that compared to a year ago, GE will be paying a 96% smaller dividend (just $0.01 per quarter). The quarterly payout is now 97% below its all-time high of $0.31 per quarter in 2007. Literally, the remaining token payout is purely to allow some mutual funds that only invest in dividend stocks to continue owning the rapidly shrinking industrial conglomerate.

This is an important lesson that no dividend is every truly “safe”, not even from blue chips or dividend aristocrats. All dividends are set by the Board of Directors and while dividends tend to be stable and reliable, that’s only on the aggregate level.



For example, since WWII the S&P 500’s dividends have actually held up very well, even during recessions and some nasty bear markets. In some economic downturns, the market’s total dividends even went up. This is because American companies know that income investors treat every dividend as perpetual and so companies that reduce payments are severely punished.

But at the individual company level, it’s important to remember two things. First, dividends are only “safe” if three things hold true:

• A company’s sales, earnings, and cash flow are relatively stable or growing over time
• The dividend is covered by earnings or cash flow
• The balance sheet is in good shape

What caused GE to slash its dividend 97% over the past 11 years? Well, that would be the rapidly shrinking nature of its cash flow and the terrible balance sheet. GE’s cash flow, even in 2018, will likely have been enough to cover the payout.

The trouble for GE is the terrible capital allocation decisions made by former CEOs Jack Welch (who turned GE into a massive financial company) but especially Jeffrey Immelt. Immelt is the only CEO in US history to buy and sell over $100 billion in 16 years as CEO. That included such disastrous ideas as buying WMC in 2004, a subprime mortgage company. That was sold for a major loss in 2007. But, GE’s subprime assets continue to haunt it — even to this day. Immelt also overpaid for no less than nine oil & gas companies between 2010 and 2014, when oil prices averaged about $100 per barrel.

Immelt dismantled GE piece by piece, including selling off the safest and most profitable parts of GE finance. Then he either blew the proceeds on terrible acquisitions or bought back tens of billions in shares. All while ignoring the terrible state of the balance sheet. That includes a pension plan covering 691,000 former employees and dependents that, before this year’s $6 billion top off, was $31 billion underfunded (the most underfunded pension in Corporate America).

The takeaway for investors is to never ignore terrible management. Sure all executives will occasionally make mistakes, especially in M&A. But for most corporations look at a company’s returns on invested capital or ROIC. This is a good proxy for quality management that includes all previous capital allocation decisions, including R&D spending, acquisitions, and overall growth CapEx investments.

If a company’s ROIC is steadily falling over time, it might be a good idea to take a hard look at what’s going wrong and potentially sell a company that isn’t investing shareholder capital well. For example, when Immelt took over as CEO of GE the ROIC was 29.6%. That means that for every dollar of shareholder capital (debt and equity, including retained earnings), the company was generating excellent annual returns of 29.6%. Today, GE’s ROIC is just 2%, showing that the much smaller company is 94% less profitable than it was 17 years ago.

A few bad years does not break an investment thesis. But steady erosions in ROIC signals that a company’s captain might be drunk at the helm, and investors might want to abandon ship.

Investing Should Never Be Done in a Vacuum

GE is a clear example of how once former great stocks can collapse in spectacular fashion. Long-term investors who held on because of a misguided belief that “buy and hold is best” ultimately suffered massive income and capital gains losses. The best investing strategy is actually “buy until the thesis breaks.” Never forget that all companies have competitors, and in the case of GE, almost all of its rivals were far superior places to entrust your hard earned money. That includes industrial conglomerates such as:

• 3M (MMM): dividend king
• Illinois Tool Works (ITW): dividend king
• Roper Technologies (ROP): dividend aristocrat
• A.O Smith (AOS): dividend aristocrat

Also, don’t forget that while diversification by sector is important your portfolio should ultimately be built to best fit your individual needs. For example, AT&T is a dividend aristocrat (34 straight years of dividend hikes) that is high-yielding. But you can find a similar yield with pipeline blue chip (and in 2020 a dividend aristocrat) Enbridge (ENB). AT&T yields 6.9% today but offers a weaker balance sheet and just 2% dividend growth. Enbridge yields 6.6%, has a booming business and 10% dividend growth.

If your goal is safe and growing income, then AT&T is a far worse investment than Enbridge (which happens to be one of the most undervalued high-yield blue chips you can buy today).

An investor’s goal should be not just a well-diversified portfolio, but one in which each sector is represented by the best companies in each sector. That might mean blue chip industry leaders, or potentially faster growing smaller but high-quality stocks. And don’t forget that over time things can change. Once great companies can see their growth slow to levels that no longer meet your needs. At such times it might be a good idea to sell even solid (but slower growing) blue-chip dividend stocks to buy undervalued, faster-growing companies that meet your portfolio’s overall goals better.

For example here are the goals of my high-yield income growth retirement portfolio:

• Safe yield of 5+%
• Long-term dividend growth of 10+%
• Total Returns 15+% (helped by buying quality stocks when they are deeply undervalued)

And keep in mind that thanks to the market being highly irrational in the short-term (something great is always on sale) I’m actually able to achieve far better fundamental portfolio stats than that:

• Safe portfolio yield: 6.2%
• Five-year average dividend growth (organic hikes): 15.9%
• Average discount to fair value: 32% (calculated using Dividend Yield Theory)

With a portfolio generating that level of low-risk income and growing at a torrid pace (one-year dividend growth rate 20.9%), and that’s so incredibly undervalued, I’m sitting on a potential gold mine when it comes to long-term total returns. That’s because since 1966 the best way to estimate long-term CAGR returns for dividend stocks is with the formula: yield + long-term dividend (a proxy for EPS and cash flow) growth + valuation boost (yield returning to historical norm over time on an annualized basis).

Plugging in my current portfolio stats, I could hypothetically achieve 6.2% + 15.9% + 3.9% = 26% CAGR total returns. That’s over 10 years which is the longest it takes quality companies to return to fair value (most do within 5 or fewer years). In reality maintaining, 15+% dividend growth for a decade is not realistic. But with proper capital allocation/stock selection, I’m confident that I can achieve the long-term targets, which would still be realistically capable of generating 16% or better annual returns. That’s good enough to quadruple my investment every decade and ultimately achieve financial independence.

Your personal goals will be different, and thus the right fundamental portfolio yield and dividend growth targets will be unique. But never forget that your portfolio is actually a business (a holding company for other businesses). Thus you should have a clear goal in mind for what you want your portfolio to achieve, and periodically check in on your employees (companies) to make sure they are on track to hit their long-term targets.

Bottom Line: Investing Is All About Managing Risks And Your Limited Capital Well

GE’s epic failure is an important lesson that there are no certainties on Wall Street. Even the bluest of blue chips can fail, and even dividend aristocrats can be forced to slash their payouts.

This is why it’s always important for investors to periodically check in on their companies. For most once a year is sufficient. For blue chips, you can stretch that to two or even three years for dividend aristocrats or kings. But never ignore four or more years of deteriorating fundamentals, including sales, earnings, cash flow and returns on invested capital.

This is especially critical since investing is never done in a vacuum. There are thousands of potential companies to invest in, including several hundred quality dividend payers. Heck, there are 53 dividend aristocrats (25+ straight years of dividend growth) and 26 dividend kings (50+ consecutive years of payout hikes) from which to start your search for quality blue-chip income growth stocks.

While not every aristocrat is worth owning (some might not meet your portfolio’s goals), there are plenty that offers either high and safe yields, or moderate yields and fast (8+%) dividend growth. And of course, there are plenty of future dividend aristocrats (and champions who aren’t in the S&P 500) that are also great places to put your money.

The bottom line is that with so many great opportunities out there to earn generous, safe, and steadily rising income, there is no reason that investors should cling to perennial fundamental losers (poor capital gains are not a reason to sell, only declining fundamentals). Especially since there’s always some quality blue chip on sale, even during the hottest of bull markets.

Remember that your portfolio is like a business, and what stocks you buy (and what prices you pay) is your capital allocation. Avoid the mistakes that Jeffrey Immelt made at GE. Don’t overpay for companies, don’t overtrade, and whatever you do, don’t ever ignore steadily deteriorating company fundamentals.

It’s been a rough October, with the stock market having one of its worst months in nearly a decade. In fact, at one point the S&P 500 and Nasdaq fell into a correction, the second of the year. Now stocks appear to be bouncing back nicely, with two solid days of gains.

Does this signal that the correction is over? Or merely a false bottom that will soon be broken as stocks resume their previous decline? Find out the three most important things investors need to know about this latest correction, including whether or not it’s actually over.

We’re Unlikely In A Bear Market

To understand whether or not stocks are done falling first it’s important to understand the different kinds of market downturns.

• Pullback (5% to 9.9% decline from all-time high)
• Correction (10% to 19.9% decline)
• Bear market (20+% decline)

According to Sam Stovall from the American Association of Individual Investors, since WWII there have been 57 pullbacks:

• On average one every six months
• Average decline 7%
• Average duration (peak to trough) 1 month
• Average recovery (to new all-time high) 2 months

Correction is less frequent, with there having been just 25 of them since 1950 according to Yardeni Research. On average corrections take about three months to bottom and see stocks fall 12% at their peak. It then takes about four months for the market to return to new all-time highs.

Bear markets are the rarest, there have been just 11 of them since WWII. On average they occur every 6.5 years and see stocks decline 33%. The median time it takes for stocks to recover to new highs is 15 months, though it can take as long as 69 months (1973).

Ok, but how do we know if this is a bear market or just a regular correction? Should we be “greedy when others are fearful” when stocks hit -10% (as they recently did) or hold on for even steeper declines? To answer that it’s important to know the biggest fundamental difference between corrections (and pullbacks) and bear markets.

• Pullback/correction are risk-based
• Bear markets are fundamentals based

There are always risks to investing (and life in general). Risks are merely things that could go wrong to derail positive fundamentals that drive stocks up over time. These include a growing economy and rising corporate earnings. Bull markets (and economic expansions) don’t die of old age, something (sharp negative shock) has to kill them.

A pullback/correction can occur at any time, for any reason. They are triggered by some combination of factors, usually short-term surprises that suddenly spook investors into “risk off mode”. For example, in February it was a sharp spike in 10-year yields caused by unexpectedly strong wage growth from the February Jobs report that caused investors to realize that valuations had become too high.

Specifically after a freakishly low volatility year in 2017 (stocks rose 20% without ever falling even 3% from all-time highs), and a continued melt up in January the S&P 500’s trailing 12 month PE (from continuing operations) hit 23.3. That’s compared to an average of 17 since 1960. The interest rate spike induced correction then took on a life of its own (fear of further selling became a self-fulfilling prophecy) and ultimately stocks bottomed after a 10.2% decline. It then took about five months for stocks to recover to fresh all-time highs (slightly longer than average).

This most recent correction has now seen the S&P 500’s trailing PE fall to 18.5 (down 20% since January), and on a forward basis to just 14.5. This actually indicates that based on the expected earnings growth of the next 12 months stocks are very attractively priced.

Bear markets, on the other hand, are not about risks (fears of what might go wrong) but are usually caused by something actually going wrong. For example nine of the last 11 recessions (82%) coincided with recessions. It usually takes actual negative economic and earnings growth to cause stocks to fall over 20%. The big exception is when stock valuations are extremely high, as occurred with the tech bubble of 2000. Today’s valuations do not pose a major risk of a non-recession bear market.

What we’re facing today is merely risks, that could slow growth, but are, at least so far, not causing it to move in reverse. What’s more, the risks we’re facing, Fed rate hikes, escalating trade war with China, and a stronger dollar, are not new. They have been around for months, it’s just that now investors are in “risk off” mode and focused purely on what can go wrong instead of looking at the actual facts of what’s going right.

How can I be confident that we’re not headed for a recession? Well because I track the economy very closely each week, via no less than seven models that look at 19 forward economic indicators (proven over time to warn of recessions).

Right now here are the best estimates we have of the probabilities of a recession starting:

• Within the next month: 0.3%
• Within the next three months: 0.75%
• Within nine months: 24%

In fact, according to BlackRock’s Byron Wien, his team’s economic model says the start of the next economic downturn is coming in 2021…at the earliest. The bond market, the best recession predictor in history, agrees, with an estimated recession start date between mid-2020 and mid-2021 (December 2020 most probable).

But don’t stock forward-looking? So the bear market might begin (stock market peaks) much sooner, right? Indeed on average, the stock market peaks about 8 months before the start of most recessions. However, according to Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch, currently, the 19 leading market/economic indicators the bank tracks indicate the next bear market isn’t likely to start for 21 months (July 2020). This is roughly in line with what the bond market and BlackRock are predicting in terms of the next recession start date.

Ok, so maybe this most recent downturn is just a run of the mill correction and not the start of the next big market slide. But that just because stocks aren’t likely to fall another 10% to 15% from here doesn’t necessarily mean stocks are done falling in the short-term.

BUT We May Not Have Bottomed Yet

It’s true that there are five reasons that the correction will soon likely end and we’ll likely see a nice strong rally by the end of the year. However, we have to keep in mind market history as well. While never a 100% accurate forecaster, market history can provide a rough guide of what average downturns do. For example, historically when stocks fall 8% or more during October, the last two days of the month see a strong rally (average 2.8%). That’s exactly what’s happening this October with Tuesday’s 1.6% rally, followed by a 1.3% rally on Wednesday (at least as I’m writing this).

So what does market history have to say about corrections that occur in a healthy economy (what we have now)? Well according to Ben Carlson, director of institutional asset management at Ritholtz Wealth Management since 1928 the average correction that didn’t result in a bear market lasted 132 days and saw stocks decline a peak of 14%.

This correction saw stocks hit exactly 10%, which indicates that at least historically speaking, we might still be 4% from the eventual bottom. That’s because corrections usually end after what’s called “washout” days. That’s when the market falls hard one final time, washing out all the weaker investors who capitulate and sell in a blind panic. That’s what causes valuations to fall so low that bargain hunters step in and the market begins its average four-month recovery to fresh all-time highs.

While we’ve seen a drop as large as 3.1% in the S&P 500 this correction, thus far it doesn’t appear we’ve had a washout day. So does that mean that investors should be using this recent small recovery rally to sell and then wait to get back in 4% cheaper? Not necessarily. For one thing, historical analysis is only a very rough guide. Every correction is different and we can’t know exactly how far or how long stocks will fall this time.

What’s more according to Deutsche Bank starting on Monday, November 5th, about $14 billion per week of buybacks are likely coming that could very well put a floor under the market. In addition since 1950, the market has usually rallied 9% to the end of the year following a midterm election (Tuesday, November 6th).

In other words, this correction, just like the last one (also 10% decline) might end up being milder than the historical average, or it might not. So what should investors be doing when faced with such uncertainty?

What Investors Should Be Doing Now

It’s important to always remember that stocks are naturally volatile at times. At the very least investors need to accept and come to terms with this fact. But the best thing you can do is actually embrace volatility as you would a lover. That’s because stocks don’t do well over time despite volatility, but precisely because of it.

Times of peak volatility means not just crashing prices, and incredible bargains, but also is what actually drives all the market’s long-term gains.

The market’s biggest single daily gains tend to come during bear markets when volatility is at its peak and stock valuations are at their lowest. Why does this matter? Because to earn the kind of great returns stocks deliver over time requires you to capitalize on those strong daily gains.

Over the past 20 years, there have been just over 5,200 trading days. Investors who tried to time the market and missed out on just the best 10 single days saw their total returns cut in half. Those that missed out on the best 30 days actually earned negative total returns. And missing the best 50 days, less than 1% of the total time the market was trading, meant stunning long-term losses. In fact, over the past 20 years missing those top 50 single best days would have meant your portfolio actually shrank 60% over half an investing lifetime. This means that for market timing to work means not merely avoiding bear markets. It actually requires pin point precision, by short-term trading in and out of markets during the very times of peak panic and fears most investors wish to avoid.  

The good news is that buying and hold investing in quality companies (or passive index funds if you don’t have the desire to stock pick) is a great time-tested strategy for most investors. In order to protect your wealth and standard of living from the market’s periodic downturns, you should use the right asset allocation or mix of stocks/bonds/cash equivalents that’s right for you. Talk to a certified financial planner to work out the specifics, but in general, the idea is that you should have enough cash on hand to cover two to four years of expenses (if you’re retired). That way you can avoid becoming a forced seller of stocks at the worst possible time, but rather only sell when your investments have had time to recover.

Bonds are a source of income, and generally either decline less during a bear market, or most of the time appreciate due to falling interest rates (during a recession) increasing their value. Thus the right asset allocation can help you to not just cover your expenses during a market downturn, but also provide you with some income and peace of mind. And of course, a quality dividend portfolio is also a great way to achieve your financial goals since dividends tend to be far less volatile than share prices.

That’s because companies know that income investors will often badly punish a stock that cuts its payout, and thus tend to avoid doing so unless absolutely necessary. Ideally, you can build up a large enough nest egg to live 100% off your safe and steadily rising dividends. If so then you can safely over allocate your portfolio in stocks knowing that your passive income will cover expenses no matter what share prices are doing. That’s my plan for my own high-yield income growth portfolio.

If your portfolio isn’t large enough to achieve this? Well, that’s where asset allocation comes in and can keep you on track to reach your financial goals even when the stock market plummets.

Bottom Line: This Correction Is Likely Close To Over But May Not Have Ended Yet

While it’s impossible to precisely time the bottom of a correction, history can offer a rough guide to what this correction might look like. That includes how long it’s likely to last, and how bad it might become.

The good news is that the current downturn has lasted long enough that we’re likely near the bottom. However, we have yet to see the kind of normal washout that generally locks in the final lows from which the market proceeds to rally to new highs. But this doesn’t mean investors should try to time the market and sell their positions now in fear/hope of lower prices in the near future.

There are numerous short-term catalysts, both seasonal, historical, and fundamental, that means stocks might continue rising through the end of the year, or at the very least not retest the recent lows. Ultimately the best thing to do is stick to your long-term investing plan. That means trusting your asset allocation, not market timing, to minimize angst and realized losses during market declines.

If you have dry powder than the last few weeks were a great buying opportunity for quality stocks, including the 11 I’ve been buying by the bucket load. And if we indeed do break through to new lows before this correction is over, then you may still have the chance for some great bargain hunting.