The danger of leverage

In the United States and many other industrial countries, the recent financial crisis contributed to the longest and most severe economic contraction since the Great Depression. The rapid expansion in the use of borrowed money, or leverage, by households in recent years, is one factor that may help account for the virulence of the downturn.

Household leverage ratios: Debt/Disposable income

Going forward, the efforts of households in many countries to reduce their elevated debt loads via increased saving could result in sluggish recoveries of consumer spending. Higher saving rates and correspondingly lower rates of domestic consumption growth would mean that a larger share of GDP growth would need to come from business investment, net exports, or government spending. Debt reduction might also be accomplished via various forms of default, such as real estate short sales, foreclosures, and bankruptcies. But such deleveraging involves significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores.

Source: FRBSF Economic Letter, Reuven Glick and Kevin Lansing

Richard Love on Superperforming stocks

First consideration in buying a stock is safety. Safety is derived more from the good timing of purchase and less from the financial strength of the company. (All stocks decline in bear markets. When there is no risk appetite, there are no buyers.)

Most stocks are price cyclical. Buying stocks as the market rebounds from bear market lows is the safest time and it offers the best opportunity for large capital gains. (Sellers cover their short positions, large size buyers are stepping in and indexes are rising above their rising 50 dma)

A winning combination in potential Super-performing stock is rapidly rising earnings, a small supply of stock, low P/E, and a product that promises strong future growth. (Investor’s job is to decide 1) when to buy; 2) what to buy) and 3) when to sell; the future best performing stocks have already doubled in value and are close to new 6 months high)

Some of the strongest price moves have been a result of severe imbalance between limited supply and huge demand of investors. Opportunities for a big gains in stock market are most likely to occur in relatively small companies than in companies with many millions of shares outstanding. Look for small company introducing a unique product that is likely to become widely used. This is the combination that has time after time resulted in dynamic growth.

Financial leverage in a stock is often responsible for high volatility in the stock’s price. Companies with high % of debt in their capitalization tend to have very volatile earnings. A relatively modest increase in income in such companies leads to disproportional increase in EPS.  Airlines and retailers are best examples of high leveraged companies. During periods of recession, when profits decline for most businesses, companies that have large amounts of debt sometimes have no profits at all. But as the national economy emerges from recession, corporate sales and profit margins improve. The % increase in profits can usually be larger than for stocks with small leverage. Highly leveraged companies, then, are even more business cycle sensitive and often are buying opportunities when the stock price is depressed.

Mark Minervini on discipline

Other than selling stocks short, I don’t know of any long-side method that works that great in a bear market. Very few stocks, even value stocks, can survive the wrath of a true bear decline.

The best leading stocks generally see their big performance a year or two into a bull market. I focus on those stocks in order to make a huge return in a relative short period of time. There is no need to be in the market all the time; in fact, I think there is grave danger in doing so. It’s like going out on a boat trip: you want to go out when the sky is blue and the seas are calm. Sure, you could stay out there and brave a hurricane and there would be a chance you’d make it through, but why would you want to do that, and how many times would you survive those conditions?