If you are buying stocks, you are a making a big mistake.
I know, I know… all the contrarian indicators are flashing green: Stocks are way down. Insiders are buying. The Fed declared to keep interest rates at 0% into 2013.
The little trust that investors regained in the market over the last two years has been completely shattered.
A survey released this week by MFS found investors are sitting on 26% cash, and they’re building more cash reserves by selling into the recent volatility.
Even Donald Trump, who rarely buys stocks, said he bought Bank of America (NYSE: BAC) and Citigroup (NYSE: C) this week. And Christian DeHaemer, my colleague who has successfully profited through every type of market you can imagine, has astutely pointed out “this is not 2008.”
I’m not saying stocks are a buy here or not. Frankly, there’s no way to tell where markets are going to head in the short term.
There is, however, a much better bet than stocks right now.
This often overlooked corner of the market is currently safer than stocks. It offers significantly more upside than stocks. And when it has fallen to current levels in the past, investors were handsomely rewarded.
Better than Stocks: Less Risk and More Upside
One of the most little-watched corners of the markets is Closed-End Funds (CEF) — and for good reason.
CEFs are funds that trade like normal stocks. They usually contain a broad basket of stocks or bonds and move up and down with the overall markets. They are controlled by the same inept fund managers who consistently fail to even match the market, let alone beat it, and consistently lag the overall markets by a wide margin.
In short, CEFs are normally terrible buys.
The past week, however, has been anything but normal. And it’s created one of the rare times when CEFs outperform stocks in general.
You see, since CEFs aren’t marked to market at the end of each trading day, they trade at the price the market will bear. As a result, their Net Asset Values (NAV) can vary widely from their trading prices on the open market.
When CEFs trade below their NAV, they are discounted; when they trade above their NAV, they’re at a premium.
During periods of extreme pessimism, you can buy them at significant discounts to their NAV. In essence, you can get into a broad basket of stocks or bonds at 10% to 15% less than market value. It’s the equivalent of buying stocks for 85 or 90 cents on the dollar.
One of those rare times of intense pessimism is right now.
Most CEFs are trading at significant discounts. The significant discounts are a great signal for investors looking to get in cheap and for the markets in general.
The Best “Buy Indicator” You’ve Never Heard Of
On average, between 50% and 65% of all the 600 or so CEFs trade at a discount to their NAV. Remember, they’re normally terrible performers. The market knows that. And it discounts the majority of them for it.
The discounts will usually range from as much as 10% to as little as 1% for some of the top-performing CEFs. And during times like now, those discounts will double — or more. Right now, most CEFs are trading at a greater than normal discount to NAV. More importantly, a far greater number of them trade at discounts than they do normally.
Consider this: The CEF discount-to-premium ratio, which compares the number of discounted CEFs relative to those trading at a premium, has fallen to levels last seen at the peak of the market meltdown in 2008.
Nearly all CEFs were trading at a discount at the market bottom in late 2008 and early 2009. At the peak of pessimism, 91% of CEFS were discounted — far higher than the normal range of between 50% and 65%.
After the past week’s wild swings, the percentage of CEFs trading at discounts to NAV has surged to more than 85%.
According to CEFs, this downturn is almost as bad as 2008. For a number of reasons though, this is not 2008.
And if you’re looking to jump on a potentially quick rebound in stocks, CEFs at these levels are the best way to do it.
CEFs Were Just too Cheap to Pass Up.
The last time CEFs were this out of favor was during the bottoming out process in late 2008 and early 2009.
While most investors were dumping anything at any price, CEFs were just too cheap to pass up. And your editor used the inherent advantages of CEFs to score a safe double and collect a 12% annual yield…
Back then, no one knew when the fall would stop. The S&P dropped below 700 and was still falling. Even convertible bonds — a unique type of investment that offers the upside potential of stocks along with the safety and income of bonds — were trading at multi-decade lows.
I even tracked down John Calamos, who is known as the “King of Convertible Bonds” and manages more than $20 billion, to see if we were on the same page…
He told me, “The marketplace has presented us with an opportunity to buy a lot of convertibles below what their fixed income values would be, and with embedded equity options which are free.” That’s institutional investor-speak for “a ridiculously easy buy.”
The problem is convertible bonds are almost exclusively bought by institutional investors for their hedge funds, mutual funds, trusts, etc.
Some of those institutional investors, however, also run CEFs. They can and do buy convertible bonds for those CEFs. And the drop in convertible bonds and massive discounts in CEFs created a rare opportunity to make large gains and collect big dividends with very little risk.
For example, the Calamos Convertible and High Yield (NYSE: CEF) — run by Calamos — was trading at a 15% discount to NAV and yielding more than 12% in early 2009.
Since then, the Calamos fund has recovered well and delivered returns better than stocks in general:
The chart shows the value of the fund has more than doubled. It has paid out more than $1 per share each year in distributions as well. The extreme discount has also disappeared, adding an additional 15% in gains.
That’s how buying CEFs at the right time can outperform stocks, reduce risk, and — in this specific case — provide much better liquidity than buying stocks or bonds directly.
That’s the advantages of CEFs when used for the right purposes and bought at the right times.
Better Than Stocks
The recent market carnage has decimated CEFs. Discounts have been driven down to levels not seen since the height of the credit crunch.
Granted, there are no guarantees when it comes to investing; Mr. Market has a way of consistently doing the exact opposite of what most investors are expecting and punishing them for taking too much risk.
With the majority of CEFs trading at greater than normal discounts to their NAVs, you can get exposure to any potential rebound, get greater upside potential if the market rally continues as the discounts shrink, and do it all with less risk than stock buyers are taking on right now.
CEFs are normally a bad idea. Rarely, they are a great idea… If history is any indicator, now is one of those rare times.
Analyst, Wealth Daily