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Leverage, the Double Edged SwordDr Richard
Appel Americans have become seduced by their greed and their urge to gamble. Witness the proliferation of state lotteries, online gambling, the evolution of Las Vegas from, in the words of a local cab driver, "essentially a honky-tonk town into one exuding glitz and extravagance", the veritable explosion of common stocks, skyrocketing housing prices, and on and on and on. The late 1960's brought our conservative nation its first state lottery. It offered a million dollar or so first prize and was not an immediate success. At about the same time the Las Vegas "strip" was primarily composed of a multitude of small motels, restaurants, casinos and stores. Block after block of these one and two story buildings dotted the strip with only a few of its largest casinos standing more than four stories tall. Atlantic City and the burgeoning number of other gambling destinations didn't even exist. This was a time when the Dow Industrials were struggling to breach the 1,000 level, and a nice middle class home was in the $20,000 to $40,000 price range. What a change forty some odd years have made. Today, so much money is being wagered that a single lottery entices the public with its mind-boggling prize of $50 million or more. In January, 2000, the Dow Industrials peaked at 11,722. Further, my recent evening in Las Vegas stunned me with its lavish, towering edifices. The city looks nothing like it did on my last visit only seven years earlier. Not only has the Las Vegas airport multiplied five or ten fold in size, but the new "strip" has greatly expanded. In fact, I was hard pressed to find a building as low lying as the largest casino of the 1960's. All of the small buildings have been razed and in their stead are massive, towering edifices. They even have their own Empire State Building look alike! As one member of my group jokingly remarked, "what would someone stumbling upon Las Vegas five hundred years hence think was its purpose". It was truly a thought provoking comment. Regarding the housing market, a similar comparable home of that earlier era now costs $300,000 to $500,000 or more. Some would say that these changes are strictly a function of "progress" or of a great growth in our population. But to me they represent the outcome of the growth of the urge to gamble, and the greed that underlies and drives that lust. For only a dollar one now has the chance to win a lottery fortune. With a small sum of money some lucky soul can strike it rich in Las Vegas or Atlantic City. Fortunes were first made, and many were later lost, when the Industrials initially stunned the world by traveling from below 1,000 in 1982, to its final 11,722 peak, only to later plunge to near 7,000. Their greed drove multitudes of so-called investors to use margin or to buy options or use other derivatives in their quest to maximize their profit potential. For homeowners, as little as 5% or 10% and occasionally zero down, bought them their first home, and later their second and possibly third ones in their pursuit of wealth. Where does it end, or does it end? We don't want it to! But as night follows day it will, and those who will suffer the most are those who are the most leveraged. Leverage in a market sense refers to using a small sum of money to control a larger dollar value of assets. The omnipresent urge to gamble has consumed the American psyche and has caused the proliferation of an increasing array of ways to leverage one's potential profit. Purchasing a $500,000 home for 10% down allows its owner to require only $50,000 to own a $500,000 asset. If the dwelling appreciates to $550,000 he can double his money. If it doubles in price to $1,000,000, he can make ten times his original investment. Further, if he owns his primary residence for over two years his profit isn't even taxed. In the stock market an investor can acquire shares of his favorite company for as little as 50% of the trade's value. This allows him to control $10,000 worth of stock for only $5,000. If it doubles in price he can triple his original investment. It gets even better if one buys put or call stock options. If you purchase options that are either far out of the money or have little time left before they expire, you can load up for pennies on the dollar. If you buy 100 put or call options of a $50 stock at $1 apiece, you can control thousands of dollars worth of the underlying stock. In this fashion your $10,000 of capital will let you profit from the fall or rise of $500,000 worth of stock. That is if you're right in both your stock choice and your timing. A 10% change in the stock's price could easily make the agile investor $40,000 to$50,000; a four or five for one score. If the stock skyrocketed and doubled in price, and your timing was exact, you could walk away with a cool half a million dollars. Why not buy 1,000! Better yet, in all of these cases if you borrow the money you can leverage your leverage, by using someone else's money for your purchases. As pleasant as it is to benefit from the leverage offered by either low down payment mortgages, margin purchases, stock options etc., and to fantasize about your huge future profits, there is a downside that few people either understand, recognize, or consider. Your lovely $500,000 home that you bought with $50,000 or less, can quickly cause your down-payment to vanish if it only declines to $450,000. If it falls further in price, you will possess an asset that will be worth less than the mortgage that you must to repay upon its sale, and will saddle you with a loss. What occurs if the economy simultaneously weakens and you're forced out of work? Your bills still arrive in the mail each month whether or not you're employed. In fact, if a severe housing decline ensues after your purchase, you may even be forced into bankruptcy. With put and call stock options you can only lose the amount of your initial investment. However, when you purchase stock on margin you are responsible for the total stock loss. If your $10,000 initial purchase declines to $5,000 you will lose your entire investment. If it falls further, you must either exit your position or you will sustain more than your original investment. That is, if your broker doesn't issue you a margin call or sell you out. It can be both fun and very profitable to use leverage in fashions such as those described above during a Bull Market. Tragically, similar actions followed during a Bear Market can destroy your life. This nation has enjoyed over five decades without suffering more than a fleeting and annoying periodic recession. Similarly, we have experienced a generally rising stock market that rose from its last secular Dow Industrial Bear Market nadir at 577 level in 1974, to its recent 11,722 peak in early 2000. During this passage of time much has changed. Our nation's citizens have evolved from one of savers into those of spenders and spendthrifts. Both public and private debt have skyrocketed and personal bankruptcies are already at unparalleled levels. An increasing number of jobs have been exported overseas to benefit from far lower wages. Likewise, numerous other countries have become more competitive and have taken sales away from our domestic companies. These events will continue to pressure our employment roles. Further, the primary reason that our economy has experienced any support is because individuals have gone further into debt. Homeowners have been among the most abusive debt builders in this fashion, when they used the proceeds from second or third mortgages or refinancings, to allow them to continue making purchases. The underpinnings of the stock market are no better. The price earnings ratio of the S & P 500 is well over 20. PE ratios at this high level have historically marked the terminal phases of Bull Markets, not their inceptions. Similarly, today's dividend yields below 2% have only occurred at the end of bull runs. Further, a Dow Theory bear signal was issued during the summer of 1999. True, the Dow Industrials are still at about the 10,000 level. However, the majority of lesser quality stocks have already suffered severe declines, and this is before the Industrials have even approached their Bear Market nadir which I believe remains far on the horizon. If I am correct, our nation is on the cusp of a serious, sobering, economic decline. Common stocks remain in a Bear Market. If the Dow Industrials break below the 9800 to 10800 trading range that has contained it for eight months, it can sharply fall. Similar extended periods of low volatility have typically ended in such a fashion. It is true that the government and Federal Reserve may be able to further forestall such an event with their fiscal and monetary policy machinations. They certainly will do their best. However, I believe that the risk of common stock and real estate price declines far outweigh their present upside potentials. For these reason
I believe that it is prudent to reduce or eliminate as much leverage
as is possible. If I am wrong, you will likely miss little. If
the Industrials penetrate and remain above about 10,800 you can
always reenter the markets. If I am early in my timing, you will
remain on the sidelines but will be able to sleep better at night.
However, if I am correct and our officials are losing control
of the markets, these actions will help you lose less and weather
the approaching storm. This, while many of those around you will
not be as fortunate and will suffer the cutting edge of leverage. I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential. Please visit my website www.financialinsights.org where you will be able to view previous issues of Financial Insights, as well as the companies that I am presently following. You will also be able to learn about me and about a special subscription offer. CAVEAT I expect to have positions in many of the stocks that I discuss in these letters, and I will always disclose them to you. In essence, I will be putting my money where my mouth is! However, if this troubles you please avoid those that I own! I will attempt wherever possible, to offer stocks that I believe will allow my subscribers to participate without unduly affecting the stock price. It is my desire for my subscribers to purchase their stock as cheaply as possible. I would also suggest to beginning purchasers of these stocks, the following: always place limit orders when making purchases. If you don't, you run the risk of paying too much because you may inadvertently and unnecessarily raise the price. It may take a little patience, but in the long run you will save yourself a significant sum of money. In order to have a chance for success in this market, you must spread your risk among several companies. To that end, you should divide your available risk money into equal increments. These are all specular-tions! Never invest any money in these stocks that you could not afford to lose all of. Please call the companies regularly. They are controlling your investments. FINANCIAL INSIGHTS
is written and published by Dr. Richard Appel and is made available
for informational purposes only. Dr. Appel pledges to disclose
if he directly or indirectly has a position in any of the securities
mentioned. He will make every effort to obtain information from
sources believed to be reliable, but its accuracy and completeness
cannot be guaranteed. Dr. Appel encourages your letters and emails,
but cannot respond personally. Be assured that all letters will
be read and considered for response in future letters. It is
in your best interest to contact any company in which you consider
investing, regarding their financial statements and corporate
information. Further, you should thoroughly research and consult
with a professional investment advisor before making any equity
investments. Use of any information contained herein is at the
risk of the reader without responsibility on our part. Past performance
does not guarantee future results. Dr. Appel does not purport
to offer personalized investment advice and is not a registered
investment advisor. The information herein may contain forward-looking
information within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of
1934. In accordance with the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995, the statements contained
herein that look forward in time, which include everything other
than historical information, involve risks and uncertainties
that may affect the company's actual results of operations. ©
2004 by Dr. Richard S. Appel. All rights are reserved. Parts
of the above may be reproduced in context, for inclusion in other
publications if the publisher's name and address are also included
for credit. |
