Wall Street's Favorite 'Drug' Won't Kill the Stock Market - Yet

by: Marc Courtenay

Leverage can be a good thing when used carefully. Like the prudent use of a margin account or buying stocks with minimum margin, it can add a little "bang" to our bucks.

This goes for buying long-term options (LEAPs) as well. Recently I bought a LEAP on Hess Oil (NYSE:HES) which allowed me to control the movement of 100 shares of HES for about 18% of the cost of 100 shares, which at the time were selling close to $80.

I agree with Jeff Clark who wrote this morning in his column that the misuse of leverage can be addictive, and it can end in a vicious cycle of lies and deceit, which will eventually destroy a person or a company (think of Enron!).

Yes, Jeff made some excellent points as follows:

"The use of leverage killed the returns of several hedge funds last week. They were all smoking from the same crack pipe. They borrowed money for next to nothing and leveraged their commodity trades. More oil… more gold… more silver."

"It's a strategy that generated huge returns until it wiped everyone out. BlueGold Capital Management lost $500 million (roughly 20% of its capital) last week… and now shows negative returns for the year. Clive Capital, the world's largest commodity hedge fund, lost $400 million and is reported to be underwater for the year. Astenbeck Capital, the well respected Phibro-owned fund run by Andrew Hall, dropped 12% last week. And the list goes on."

The lesson here isn't anything profound or unique. Excessive use of leverage is very dangerous. Just like the use of options, everything is wonderful as long as the market is moving in your direction. But one sudden reversal in the trend can and often does wipe out months of gains overnight.

Another, much safer form of "leverage" is what I call "time-and-price leverage," and it's more of a "vitamin supplement" than a "drug." This involves giving yourself some "free leverage" by waiting for a better time to buy a stock or ETF. That happens often after a gut-wrenching correction--just like we've seen in oil, silver, copper and some other commodities as of late.

It has allowed me to buy companies like Anadarko Petroleum (NYSE:APC) around $74 a share, which is quite a ways off its recent 52-week high of $85.50. If Jim Cramer is right and oil falls to around $90-a-barrel, then I can buy more shares at even lower prices.

I used "time-and-price leverage" to pick up my first tranche of shares in Freeport-McMoRan Copper & Gold (NYSE:FCX) yesterday at close to $48 a share. FCX is selling at less than 8 times forward earnings. It's most recent quarterly earnings growth (year-over-year) was a staggering 59% and its trailing-twelve month operating cash flow was close to $7 billion.

And today Pan American Silver (NASDAQ:PAAS), one of my favorite silver producers hit my buy-limit price of $31.34, which luckily was the low of the day.

PAAS is selling for less than 11 times forward earnings, its PEG ratio (5 year expected) is a measly .22--it has total debt of around $26 million and total cash of over $360 million, and as I write silver is still above $35 an ounce.

The "time-and-price leverage" has worked for those who wanted to buy shares of Silvercorp Metals (NYSE:SVM) close to $10 a share (down 37% from its 52-week high), and has helped the patient investor accumulate Silver Wheaton (NYSE:SLW) at lows today of $32.43, down 32% from recent highs of $47.60.

SLW is a way of "leveraging" the price of silver, because the company makes its profits by buying at super-cheap prices the ancillary silver that gold, copper, lead and zinc companies produce as a form of supplemental "tailings".

SLW thus operates as a "silver streaming company" worldwide and has 14 long-term silver purchase agreements that allows it to "buy low and sell high" without the hassles or mess of silver mining production. What a business model!

Yes, I'm concerned that margin debt on the New York Stock Exchange has surged to its highest level since February 2008. This was just before the S&P 500 (NYSEARCA:SPY) dropped by half.

Net leverage on the NYSE is now the second highest ever recorded. The only time in history leverage has ever been higher was back in June 2007. Yikes, that was the absolute peak of the credit bubble.

Yet as long as the Federal Reserve's monetary policies remain as they have been and the economy (especially unemployment and housing) remains vulnerable and "soft", we are likely to see the stock market averages higher by the end of the year.

There is cause for carefulness right now, and the "seasonal factor" may make that more relevant. But in this third year of the "presidential cycle" the stock market typically does well, and we have a ways to go before we recapture the October 2007 highs of over 14,000 on the Dow Jones Industrial averages.

Yes, there has been a great deal of manipulation and "intervention" in the markets in the past year. Yes things seem frothy while at the same time we could make an argument that the market is "climbing a wall of worry".

Paradoxically, even though companies like Cisco Systems (NASDAQ:CSCO) are lowering their forward earnings guidance and generally disappointing investors, there are still companies out there that have massive upside potential. That's what some people think about NXP Semiconductors (NASDAQ:NXPI) or even Cisco competitor Juniper Networks (NYSE:JNPR)

Another example is the Chinese solar energy company Trina Solar (NYSE:TSL). Talk about "undervalued", at least by an earnings multiple standpoint. And some big energy companies are taking notice of the value of solar energy.

Recently French energy giant Total (NYSE:TOT) announced that it will purchase up to 60% of SunPower (Nasdaq: SPWRA) for about $1.4 billion. This is a strong vote of confidence in the future of solar energy.

A few days ago, the Trina Solar’s U.S. subsidiary signed a sales agreement to supply 35 megawatts of solar modules to Fotowatio Renewable Ventures’ project in Austin, Texas.

Another positive sign is that Wall Street analysts are still neutral on the stock. That means there’s plenty of room for upgrades – and last week a respected independent research firm selected TSL as one of its top four oversold short squeeze candidates.

So fear and worry, like leverage and margin, will eventually take its toll on the markets. But for now the "Smart Money" and those that control the monetary policy in the U.S. are doing all they can to drive stock and commodity prices higher. If they don't prevail, then we'll have an even better opportunity to use "time-and-price leverage" to buy when the "blood is running in the street."

Disclosure: I am long HES, FCX, APC, PAAS, SVM, SLW, CSCO, NXPI, TSL.