Do not be fooled by the recent stock market run-up. Think of it as a set-up for a fall. Do not be fooled by how long insolvent organizations can perpetuate the poor capital allocation and spending decisions that created their insolvency. The euro is not that different from Enron, Worldcom or the Madoff fund. All of these organizations were able to pretend they were profitable or solvent long after they were insolvent. The euro has the distinct advantage of support from central banks around the world, but printing money, as I explain below, does not create solvency. It only delays the inevitable, albeit for a bit longer than accounting manipulation and ponzi schemes delay their inevitable implosion.
Investors need to protect their portfolios from the eventual economic decline that will stem from the euro debacle.
The shell game in Europe is ending and markets are yet to discount the structural decline in the productivity of economies around the world. These declines result from large-scale mis-allocation of capital over the past several years and in the present.
And when I write “protect” your portfolio, I mean take a net short position as I have in my portfolio. Click here for a detailed explanation of why being net short is the best way to make money now.
Whenever a general market decline is on the horizon, the best protection is shorting super expensive stocks with little underlying economic value. In other words, the stocks that will fall the hardest are those whose economic earnings are already too weak to support over-extended valuations. I recommend shorting the following stocks because they all have sky-high valuations and low returns on invested capital (ROIC), which, in these cases, result in misleading earnings (accounting earnings diverging from economic earnings):
- Valeant Pharmaceuticals International (VRX).
- Current valuation ($46.21) implies 16% compounded annual growth in after-tax cash flow (NOPAT) for 20 years.
- Low ROIC at 4.4% versus weighted average cost of capital (WACC) of 8.1%.
- Digital Realty Trust (DLR).
- Current valuation ($63.50) implies 18% compounded annual growth in NOPAT for 20 years.
- Low ROIC at 5.9% versus WACC of 8.6%.
- Zion Bancorporation (ZION).
- Current valuation ($16.09) implies 14% compounded annual growth in NOPAT for 20 years.
- Low ROIC at –2.7% versus WACC of 12.0%.
Compare the expected growth rates to historical organic growth rates and your jaw will drop, especially for ZION.
Another comparison, the current valuation of the S&P 500 (at 1,248) implies just 9% compounded annual growth for 20 years. However, the S&P, according to our model, actually generates significant profits with an ROIC of over 20%, making it economically profitable. The companies above are not currently profitable, which makes market expectations for future profit growth that much more difficult to meet.
I also recommend avoiding or shorting the ETFs and mutual funds below because they hold significant positions in the stocks above and get my “very dangerous” predictive fund rating.
- CGM Trust: CGM Realty Fund (CGMRX)- allocates 5% to DLR.
- Saratoga Advantage Trust: Financial Services Portfolio (SFPAX) — allocates 4% to DLR.
- Same applies to the B, C and I classes of the fund.
- PowerShares KBW Bank Portfolio (KBWB) — allocates 3% to ZION.
- John Hancock Investment Trust II: John Hancock Regional Bank Fund (FRBAX) — allocates 3% to ZION.
- Same applies to the C and F classes of the fund.
- Touchstone Funds Group Trust: Touchstone Mid Cap Fund (TMAPX) – allocates 3% to VRX.
- Other classes of the fund get a “dangerous” rating instead of “very dangerous” because of their lower total annual costs.