Grow Up To 1,000% Richer In The Great Stock Panic Of 2002

Chapter 25

Additional Bear Market Strategies

Unless you live more than another half century, the Great Stock Panic of the early 21st century could be the last financial crisis of this magnitude you will see in your lifetime.

That's good. It means your children and grandchildren will probably not have to go through the same economic pain again for decades. But it also means that you won't see similar profit opportunities again for a long time.

This is going to be the mother of bear markets; and in the preceding chapters, I have given you ideas and recommendations on how to harness its power.

But as in any market, more diversification, across various sectors, can help reduce your overall risk and improve your performance. Instead of counting on just one event in one sector � such as a decline in tech stocks or a crash in dot-coms � to carry the day, you can have a stake in several different trends.

Please understand: You should not run out and start implementing every single one of these today. Rather, I am presenting them here to give you a preview of the various types of strategies I will be recommending to you in my newsletter as the crisis unfolds ...

Strategy #1
Profit From The Looming Banking Crisis

Some of America's largest banks are on a collision course with major losses, driving their share prices into a "bank stock wreck" that rivals or even exceeds the great tech wreck of 2000-2001. And at hundreds of banks, these losses will wipe out the institutions' capital, drive them into bankruptcy, and destroy 100% of the wealth of their shareholders.

Here are some facts:
  • The nonperforming loans of all commercial banks and thrifts surged 27% in 2000, according to Weiss Ratings, Inc.

  • Mortgage delinquencies � loans at least 30 days past due � have soared to the highest level in eight years, and are now running at an alarming rate of 4.5% of all mortgages. This is a red flag for the thousands of banks who hold these mortgages � warning of a new, tidal wave of mortgage defaults on the near horizon.

  • US corporate debt has mushroomed to 46% of GDP � its highest level in recorded history. That means that for every single dollar of goods and services that you, I, and everyone else in this country produce each year, American businesses owe a whopping 46 cents � mostly to banks. And that excludes the debts owed by banks themselves.

  • Consumer installment debt is a bubble that's so huge, it's off the charts, and almost anything � more lay-offs, more stock market declines, or just plain fear of bad times � could puncture the bubble. I won't bore you with the hundreds of stats that support this view. But consider just this one: If you are an average American and you have a plan to pay off the average balance on your credit card with minimum payments, we estimate it would take you 30 years to do so! Hence, another major sector where defaults are bound to go through the roof, leaving the banks holding the bag!
Bottom line: The Fed can lower interest rates. And Mr. Bush can lower taxes. But if businesses and consumers are defaulting on their debts to the banks, it won't make a bit of difference. Bank profits will plunge. And it's already begun:
  • J.P. Morgan Chase & Co. saw its first quarter earnings plummet from $1.01 to just 58 cents a share year-to-year. It also suffered a 16% increase in nonperforming loans, writing off a total of $148 million in bad loans.

  • Bank of America's profits fell 17%; its nonperforming loans surged 65%; and its write-offs nearly doubled � up 84%.

  • At Bank One, earnings declined only 4%, but nonperforming loans rocketed 123%.
And all this before a major recession � let alone the Great Stock Panic � gets under way.

The good news is that there are great vehicles available to profit from the decline in bank shares. And you don't have to guess which specific bank will be the next to stumble because there are now two nicely diversified investment vehicles that you can use to profit from a decline in bank shares.

Vehicle #1. You can sell short the shares of the Financial Select Sector � symbol XLF on the AMEX. This is an exchange-traded mutual fund that represents a basket of financial companies exposed to the debt problems I've told you about in this book. For specific entry and exit points, be sure to check the regular monthly Mr. Speculator column of my Safe Money Report.

Vehicle #2. Buy put options on the Philadelphia Bank Index, symbol BKX on the Philadelphia Stock Exchange. This index is specifically focused on the nation's 24 largest banks � including the Bank of New York, Bank of America, J.P. Morgan Chase, Wells Fargo, and many more.

Although the specific strike prices and maturities can vary significantly depending on the specific market circumstances, in general I recommend modestly out-of-the-money puts with expirations under four months.

The following U.S. banks and thrifts were rated the
lowest by Weiss Ratings as of April 11, 2001.
Company Name City State Weiss
Bay View Bk Na
B&T of Puerto Rico
Life Bank
Unity Bk
First Professional Bk Na
First Savings Bank, FSB
First NB Of Nevada
Transamerica Bank Na
First NB of Lucedale
Dryades Savings Bank FSB
Bernville Bk Na
Mainstreet Savings Bank, FSB
First Security Bk
Banco Financiero De Pr
McCurtain County Nb
San Mateo
Hato Rey
San Bernardino
Santa Monica
New Castle
New Orleans
Broken Bow

Warning: Since these options are very volatile, they are not buy-and-hold investments and cannot be tracked adequately with a monthly service. They must be monitored daily or even hourly. So, for on-the-spot trading advice, consider our premium service, Stock Options Hotline.

Not interested in these more aggressive investments? That's fine. Then at least protect the safety of your banking relationship by avoiding banks that are vulnerable to financial difficulties in a recession. Sure, your deposits may be guaranteed up to $100,000 by the FDIC. But there is no guarantee that protects you from cutbacks in customer service, mix-ups with your account due to poor management, and even the termination of a line of credit your business is counting on.

So be sure to check the accompanying chart of the weakest banks in America. Plus, for the 10 weakest banks in your state, see our tables at back of this book.

If your bank is not among the 10 weakest, that's good news. But it does not guarantee that it's a safe bank. So if you would like to check the latest rating of your current institution, go to, click on "ratings online," and then on "purchase ratings online."

Strategy #2
Leveraged Profits With Bonds and Interest Rates

Despite the Fed's actions to cut short-term interest rates, a series of forces is � or soon will be � driving long-term interest rates higher:

1. More corporate bonds are being downgraded ... and the lower the rating, the higher the interest rate. Outright defaults drive corporate bond yields even higher.

2. In a money panic, the acute scarcity of capital also drives up the cost of borrowing for municipal governments, state governments, and federal agencies.

3. Even the safest and strongest borrower in the world � the US Treasury Department � will have to pay more for long-term money. Reason: The Treasury will be competing with private borrowers, with local governments � even foreign governments � for a shrinking pool of capital worldwide. And despite all the talk of "surpluses," the US government's overall budget deficit, including so-called "off-budget" items, remains huge, even after the longest prosperity in history.

So rather than give you a strategy designed to profit strictly from a decline in corporate bonds, I have decided to broaden the scope and tell you about ways to profit from a decline in all bonds.

The Rydex Juno Fund (800-820-0888) is a specialized fund that is designed to rise in value when bond prices fall. Although it is indexed to the price of 30-year Treasury bonds in particular, I believe it is a good vehicle for bond market declines in general.

But I do not recommend it as a buy-and-hold for the long term. Instead, for the specific timing of when and what to buy, the best place to go is to our Mr. Speculator column in the Safe Money Report.

Another excellent vehicle: Options on interest rate futures. But don't be alarmed by the word "futures." I am not talking about actual futures contracts. Rather, I am referring to options on those contracts.

These options are structured in the same way as the options you buy on stocks or stock indexes. When you buy these options, you can never lose more than you invest. They have a fixed strike price, and a fixed maturity date. Like all other options, the disadvantage of using them is that they are "wasting assets" � generally declining in value over time; their great advantage is the huge leverage they offer, with strictly limited risk.

Warning: As with other puts and calls, the risk is limited to the purchase price, provided you are just (a) buying options outright or (b) selling options you own. If you engage in more sophisticated and complex trading strategies � such as "writing naked options" � the risk limitation may not apply.

Therefore, when you open an account with your broker, be sure to tell him that you will be engaging only in transactions in which your risk is strictly limited to the purchase price of the options you buy. Do read carefully all the warnings of potential loss that apply to the other transactions. But bear in mind they do not apply to the transactions I am recommending.

As with any options, the options on interest rate futures can be either puts or calls:

You can buy a put option if you want to profit from a decline in bond prices; buy a call option when you want to profit from a rise in bond prices.

Which will it be during the Great Stock Panic? I expect both � first a sharp decline in bonds ... then an equally sharp rise. (See Chapter 16 for details.) Each of these is potentially going to be an amazing investment opportunity. Here are a couple of the specific instruments available to you:

1. Options on Treasury bond futures. Here's an example of how it would work: Assume you purchased a June Treasury Bond Futures put option on March 22, 2001, just before bond prices fell. You would have paid 22/64ths or $390.625 per contract. Then, after the decline in bond prices, on May 11, 2001, you could have sold it at 3 54/64 or $3,843.75 per contract. Your profit: 884%. Of course, not all trades are so profitable. But this gives you an idea of the great potential, even without a dramatic move in interest rates.

And not all Treasury bond options are that cheap. On the Chicago Board of Trade, a typical Treasury bond option � with a not-too-distant strike price and a reasonable amount of time till maturity � can currently cost from $937 to $1,734.

2. Options on eurodollar futures. Don't let the term "eurodollar" confuse you. This is not the same as the new European currency � the euro. In fact, it has very little whatsoever to do with the euro. Rather, these are US dollar time deposits held mostly at European banks � similar to US banks' CDs.

I recommend put options on the eurodollar futures when short-term interest rates are headed higher. And I recommend their call options when short-term rates are headed lower.

But it's not a good idea to trade these options based on what everyone already knows or expects about the Fed's next action. You can't just say: "Well, it's nearly a sure thing that the Fed is going to drop interest rates at its next Open Market Committee meeting. So I'll clean up by buying some eurodollar call options."

That will rarely work because the market will already have factored those expectations into the price of the futures. For example, let's say short-term interest rates are at 5%, and it's widely expected that the Fed will lower them to 4.5%. Well, if that's the case, then the futures markets will be pricing the futures contracts at a level that already factors in the interest rate cut.

Rather, to make money in these options, you need to stake out a position in anticipation of what most people do not expect. For example, when no one was expecting a dramatic Fed rate cut in early 2001, you could have made a fortune in call options on eurodollars. Ditto for put options on eurodollars when the Fed surprises the market with no rate cut, or a rate hike, a likely event during the Great Stock Panic.

What's most surprising about many eurodollar futures contracts is how cheaply they can be bought, especially when the market feels that major changes in interest rates are unlikely.

You can often buy an out-of-the money eurodollar option for as little as $19. You can buy an at-the-money option for $287.50. And each of these contracts gives you the ability to potentially control $1,000,000 in eurodollars!

Like any short-term options, options on futures are too volatile to just buy and hold. Instead, you have to watch them all the time, as we do for our premium service subscribers. My Dad pioneered the trading in these interest rate options, and started a trading service that is dedicated to them and nothing else. The service � Irving's Interest Rate Speculator � still bears his name and carries on with his approach.

Strategy #3
How You Can Get 20%-Plus Profits
From A New Bond Crisis � Without
Touching A Bond!

The corporate bond market is poised for a fall so hard it will leave a mile-wide crater on Wall Street.

Reason: US financial businesses have a grand total of $6.51 trillion in debt, according to the Fed. When the economy was roaring along, the debt was worrisome ... but tolerable. Now, as the economy begins to slow dramatically, the debt is becoming catastrophic � fast!
  • US companies defaulted on $30 billion of debt between January and March, the fastest rate ever, according to Standard " Poor's.

  • Measured in dollars, the sheer size of defaults in the first quarter is close to the full-year record set in 2001 � in just one-fourth the time. Last year, 106 US companies defaulted on $33.4 billion.

  • Investors are already recoiling in horror from junk bonds. They yanked more than $89.2 billion out of junk bond funds last year � the worst outflow in the past 10 years.
A credit panic like this is exactly what burst Japan's economic bubble and plunged it into the 12-year-long recession that's still going on today. Keep that in mind as the events unfold in the weeks and months ahead.

Also keep in mind that a credit panic is a debt monster run amuck � a situation that is beyond the power of any government authority, even the Fed, to control.

And it's getting worse � credit-rating agency Moody's Investors Service expects bank loan losses to keep rising through the end of the year, despite recent short-term interest rate cuts by the Fed.

Here's the pay-off: When the corporate bonds of weak companies fall due to downgrades and defaults, investors naturally throw the babies out with the bathwater. In other words, they sell the good with the bad, driving down the bond prices of solid companies as well. Pick them up for a deep discount and you can make money two ways:

First, you make money by locking in a solid double-digit yield. Yields of 10% or more on high-rated bonds will be common.

Second, you can make money by taking advantage of a nice bounce in the bond prices as soon as the crisis subsides, for a substantial capital gain. A 10% bounce in prices would be the very minimum you could expect. And you could even see a bounce of as much as 20%, 30%, or 40%.

Put together the yield and the capital gain, and you could easily make 20% or more from the corporate bond crisis. And you'd be doing it with relatively safe investments � bonds in some of America's strongest corporations. Another alternative: At the right time, but call options on eurodollars or US Treasury bonds and you can much, much more than 20% without ever touching a bond.

Again, right now, though, it's too soon to buy. Wait for my signals in the Safe Money Report. First, we must wait for the corporate bond market decline to unfold ...

Strategy #4
How To Profit When
Telecoms Crash And Burn

Telecommunications company Winstar Communications recently declared bankruptcy. It collapsed under $3.4 billion in debt � more than double its sales.

Winstar is an omen � the telecom industry is burdened with debts that will sink it no matter how low interest rates go.

All told, I figure the big telecom players have approximately $700 billion in debt � with $130 billion in new international bonds sold by phone companies in the past 16 months alone. This is huge.

Indeed, by the end of 2000, for every dollar of sales, the industry had a full dollar in debts. Just five years earlier, in 1995, they had only 37 cents in debt per dollar of sales. This means their debts have grown many times more quickly than their revenues. No industry can do this without suffering serious consequences.

Right now, the telecom giants have pinned their hopes on the new "3G" wireless systems, but one technological snafu after another has delayed 3G, and there's no proof that customer demand will justify the investment. The telecoms may not see a return on these huge outlays for decades.

Take a look at the list of the most vulnerable telecom stocks � companies that are practically creaking under the burden of the debts they carry.
  • Nextel Communications carries $14.7 billion in debt.

  • Sprint Corp.'s PCS Group is weighed down by $14.3 billion.

  • VoiceStream is carrying $5.7 billion in debt.
These stocks are prime shorting candidates. Some of these stocks are at high risk of going to ZERO � which means your profits will go sky-high.

But shorting isn't for the faint-hearted. Unless you're an expert, you really need professional advice when you do it. So wait for my signal on which stocks to short � and when.

And the great thing about this is that, eventually, the surviving telecoms will be oversold. You'll be able to pick up companies with incredible potential for pennies on the dollar. I'll give you signals when the time is right to do that, too.

Strategy #5
Profit From The Bursting
Real Estate Bubble

The 10 Worst Performing Real Estate Funds
Name Assets 1 Month
(Mil. $)
YTD 1 Year
Morg Stn DW In: Asan RE
Alpine Intl RE; Y
Morg Stn DW In: Euro RE
Security Cap: Euro RE
FBR: Reality Growth; A
Alpine US RE; Y
INVESCO Rl Est Opp; Inv
Merrill Real Estate; B
Phoenix-Snca: RE; X
Cohen & Steers Spec Eq
Lipper Real Estate Fd I
S & P 500 Daily Reinv

Source: Reuters
In just 12 short months, investors suffered over $5 trillion in losses in the stock market, and the April-May rally barely made a dent in the pain. But those losses could pale in comparison to the damage that I believe is likely in real estate.

Consider the magnitude of the recent boom in the hottest markets � New York, Boston, and San Francisco. Rents doubled and tripled from 1998 to 2000.

That's when new tech companies, hot off their IPOs and flush with cash, were snapping up commercial real estate and bidding up the prices into the ozone. Then the music stopped, and the party came to an abrupt end. Failed dot.coms shut their doors and pulled out of their leases. The struggling survivors downsized and relocated to smaller digs.

Result: Landlords are getting hit with a rash of vacancies.

In some parts of San Francisco, available sublease space has skyrocketed 275% to 3 million square feet, as companies closed down and moved out. Meanwhile, the rents in some commercial buildings have already been slashed by 40%. Even more ominous: One study projects that 80% of the remaining companies in the Bay Area will collapse in the next year. Result: Another 4 million square feet of office space will become vacant.

In New York, more than 20% of the office space leased by dot-coms since early 1999 has been returned to the market.

In Seattle, the vacancy rate has more than doubled from 1.7% at the end of last September to 4.2%.

In parts of Silicon Valley, commercial vacancies have reached a whopping 12%.

And it's not just existing commercial properties that are getting hit ...

The fear is spreading to developers and builders, too. Many are too young to remember the debacle of the mid-70s. But they cannot forget the late '80s and early '90s, when a deluge of sublet space hit the market just as developers were completing millions of square feet of new space. Now, they don't want to get caught again in debacles about to strike.

The Federal Deposit Insurance Corporation (FDIC) also recognizes the risk. In fact, in its fourth-quarter outlook for 2000, it specifically named the metropolitan areas it feels are at risk because of excess commercial real estate construction. Especially vulnerable cities: Atlanta, Phoenix, Portland, Seattle, Salt Lake City, Fort Worth, Dallas, Las Vegas, and Denver.

Bottom line: The commercial real estate market is about to crash to Earth, and soon. Everywhere, professionals who deal daily with real estate investors are sensing a dramatic mood change in the wake of the tech stock crash.

And the recession has barely begun! As the economy contracts, we're looking at a sinkhole in real estate prices of historic proportions. To hedge � and profit � from this crisis, consider these two strategies:

1. Short select REIT stocks: A Real Estate Investment Trust (REIT) is similar in many ways to a mutual fund, only it deals in real estate, not equities. REITS purchase and manage income property and/or mortgage loans. Now, they're going to get slammed, with those concentrated in California and other high-tech areas especially hard hit.

See the accompanying table for a list of REITS that I feel are the most vulnerable. But don't sell them short right now. Wait for our specific timing instructions in the regular Mr. Speculator column of Safe Money.

2. Sell commercial property now and buy it back cheap: If you can get a good price and you are not in love with your holdings, now is the time to sell � especially if you are leveraged and could not service your debt if your tenants leave. Just remember � you are going to get an opportunity to buy great properties on the cheap in a few years.

Strategy #6.
A Little-Known Public Company That Will Thrive
As Personal And Corporate Bankruptcies Surge

Bankruptcy is one of the very few that's guaranteed to be a growth industry in the years ahead. And it's not funny: Last year, 1.2 million Americans declared bankruptcy, a 75% increase from 1990. Businesses are filing for bankruptcy at the rate of close to 35,000 per year. And this is all before a money panic strikes.

This is not a happy story. But investors in Pre-Paid Legal Services, Inc. (PPD - NYSE) can profit from the expected boom in bankruptcies. For a small monthly fee, this company offers underwritten legal assistance that allows its members prepaid access to lawyers all over the US In other words, you pay for it like health insurance. The company has 827,979 active members in 50 states.

Members can access legal services through a network of independent provider law firms under contract with the company.

Pre-Paid is near the top of Forbes' list of the best 200 small companies. It has no debt, and is sitting on $14 million cash. It has a price-to-earnings ratio of less than 9, and a five-year earnings growth of 40%. As more families and businesses fear � or actually go through � bankruptcy, the demand for this company's services is going to go through the roof.

The company's revenues rose 28% to $247.7 million in 2000, while net income rose 23%.

Under any circumstances, this would be a great company to invest in. And when the economic downturn tightens its grip on America ... when consumers see their friends and neighbors going broke AND having to shell out expensive attorney fees ... Pre-Paid Legal Services is going to look like a bargain to many people.

I think this company will make a great investment, and I'm watching it for you carefully. But to get maximum return on your money, wait for my signal in Safe Money before buying.

Strategy #7.
Well-Known Construction Company
About To Crash Back To The Earth

USG Corp. (USG - NYSE) pulled in big bucks during America's decade-long building boom. But now it's already turning into a house of cards � and its stock price is going to take the express elevator to the basement.

USG is the leading maker of gypsum wallboard and ceiling suspension grid in the world, and the #2 maker of ceiling tile. Problem is, it's getting beaten at its own game.

USG's net sales were down 16% in the first quarter of 2001. Industry capacity has grown 10% in the last year, which is generating a tremendous amount of competition and pricing pressure. The price of USG's Sheetrock brand fell 42% in just one year. The company's net earnings in the first quarter were down a whopping 90% from a year earlier.

The company's other financials are horrible. The company has been losing money for two quarters, bleeding $354 million in red ink this last quarter. Debt is 85.6% of equity. The stock has lost 70% of its value in the last year.

And this is without a recession! If we fall into a full-scale economic malaise, USG's stock could easily tumble to $3 a share.

Adding to its troubles, the company has been named in asbestos-related lawsuits. Two of USG's co-defendants, WR Grace and GI Holdings, have filed for Chapter 11 bankruptcy. I strongly believe USG will be joining the parade into bankruptcy court. This stock is an excellent shorting candidate, but be sure to wait for our signal before committing your money. I want you to get the most bang for your buck.

Strategy #8.
This mutual fund will protect
the purchasing power of your money
and profit from a decline in the dollar.

The US dollar has soared to dizzying heights when compared to all other major currencies; and this may continue for a while longer. But as the US economy goes into a tailspin and faces a hard landing, the dollar is vulnerable to a major decline collapse.

Here's why: Between 1992 and 2000, America's trade deficit mushroomed from $47.73 billion per year to $435.39 billion.

We have been buying from overseas producers in huge amounts. But we've been selling far less. So we send them a heck of a lot more money than they send us, and massive amounts of our dollars have wound up in foreign hands.

No immediate problem � as long as overseas investors continue to ship those dollars back to the US to buy our stocks and bonds.

Trouble is, after years of investing in US securities, they're now loaded to the gizzards. Today, foreign investors own $1.7 trillion in US stocks ... $2.6 trillion in US government and corporate bonds ... and $1.3 trillion in direct private US investments. That is an incredible $5.6 trillion, equal to 56% of our country's gross domestic product.

Result: We're so dependent on overseas funds that even a small withdrawal would wreak havoc in our financial markets. And some foreign investors, fearful of a recession in the US, are already starting to pull their money out of our stock market, selling the US dollar along the way.

What happens when the Fed lowers interest rates? It just spurs more selling by foreign investors � especially those that invest in short-term money markets and Treasuries. So, in addition to selling US stocks, they will also sell US Treasuries, US CDs, and US bonds.

But no matter what they sell, the impact on the dollar is the same: It gets sold, and its value falls. What do you do when your money is worth less every day? Here's the good news: There's a little-known fund that's perfect for a plunging dollar environment. There's no sales commission to get in, and it's listed on the exchanges.

It's called the Prudent Safe Harbor Fund (PSAFX � or 888-778-2327). The minimum investment is $2,000. This fund helps protect the purchasing power of your dollars in two ways:

1. The fund devotes a portion of its assets to non-US debt securities, investing in the highest grade government securities of countries like Switzerland and Great Britain. If the dollar falls against these currencies, the value of these non-US investments will increase in dollar terms.

2. The fund also invests a small portion of its assets in gold bullion and common stocks of gold mining companies. This makes sense since gold tends to appreciate in value when the dollar falls.

Check the Mr. Conservative column of my Safe Money Report. But remember: We don't recommend it all the time or in every issue. When we anticipate the dollar is moving higher, we generally recommend you exit this fund. And we only recommend it when we anticipate a decline in the dollar in the near term.

Which of these bear market strategies should you actually implement right now? For that answer, be sure to check the Safe Money Report. Remember, these are not buy-and-hold investments. They must be timed properly to adjust to each phase of the Great Stock Panic.

And also remember my paramount advice: Keep the bulk of your money absolutely safe, using strictly your risk capital for speculative strategies such as these. With this approach you will not only harness the power of the bear market in your favor with the potential for break-out profits, but more importantly, you will protect your capital.

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