“These comparisons people make with the Great Depression are totally out of touch with reality, and pretty stupid…We’ve been in much worse, much more panicked and more scary situations in the U.S.”
That’s what Steven Leuthold said in an interview yesterday.
Leuthold is one of the most respected fund managers in the world. He is a cofounder of Leuthold Weeden Capital Management which oversees $3.2 billion assets. Leuthold is also the manager of the Grizzly Short Fund, which, as the name implies, bets on falling stocks (the practice of “shorting” stocks). The fund returned 74% in 2008. So, in an inverse way, the fund beat the S&P 500 by about 30%.
In a rare bit of honesty and forthrightness for money managers, Leuthold went as far as saying investors shouldn’t buy into his Grizzly Short fund. I don’t think I’ve ever heard any fund manager, who gets paid on fees based on total assets under management, tell prospective clients not to buy.
The only time a manager would do this is if they couldn’t find anything they wanted to buy. In this case, with a short fund, it means Leuthold can’t find much he wants to sell short.
That’s a good sign. It might not signal a bottom for the overall markets – and I wouldn’t take it as such – but it shows there are much fewer significantly overly valued stocks out there.
So, if the short-sellers are having trouble finding stocks worthy of shorting, is the market due for a rebound? Is Leuthold right? What if this is the “last great buying opportunity in stocks?”
If you’re looking to wade back into the stock market, there are ways to do it safely. There is one way to safely get your toes wet in the market. This way has historically outpaced rising markets. It doesn’t do nearly as bad when markets fall. And it actually gets better as the market gets more volatile.
It’s the best of all worlds. And it doesn’t require dealing with complicated stock options or having to sit by your computer watching the markets all day. That’s why I consider it one of the safest ways to start moving back into the markets. But first, you’ve got to understand how this potential opportunity as created.
Bull Market in Volatility
You see, we predicted higher levels of market volatility are here to stay back in October. The markets were on edge. They’re still on edge and will continue to be until some details about the future start to clear up.
For now, unprecedented government intervention overriding the markets, significantly higher earnings volatility, increasing international tensions (we’re all friends when everyone’s getting rich), and surging job destruction (and not knowing where the new jobs will be created) will only continue to add to the uncertainty.
There’s nothing the markets hate more than uncertainty.
Just look at what happened yesterday. The feds finally revealed the details of the housing rescue plan. Whether it’s a good program or not, didn’t matter. The fact that the details are now known and can the market can try to estimate the impact and then make investment decisions accordingly was a welcome relief.
But that’s just one uncertainty the market no longer has to worry about. There are still a lot of unknowns to expect a big rally (i.e. 30% to 40%) in the short term.
The Bear Case
For instance, the markets are due for another big helping of reality on Friday. It’s that time of the month and the latest U.S. jobs report will be unveiled. This time around, a loss of 500,000 would be good news. Most economists are forecasting 648,000 jobs to have been lost in February though. It’s a situation where the best we can expect is “not as bad as expected” types of numbers.
Then we have the bailouts. On the one hand, we can finally see the bottom of the AIG money hole.
The New York Times says:
“At its peak, the A.I.G. credit-default business had a ‘notional value’ of $450 billion, and as recently as September, it was still over $300 billion.”
The notional value is how much AIG had at risk if it had to pay on all of its credit default swaps (CDS). In other words, if all of the bonds AIG had guaranteed all defaulted and went to zero (yes, very unlikely), AIG would be on the hook for another $300 billion. The good news is there is a bottom to the black hole. The bad news is it could be a few hundred billion dollars away.
On the other side of the bailout issue, we still have to go through all the “stress testing.” And we can’t forget about GM, Chrysler, Citigroup, and Bank of America. Then just around the corner, you’ve got to look at the underfunded pensions, and on and on.
There’s a lot to work though here in the U.S. For time being, overseas markets aren’t looking too enticing either. Just look at China.
We’ve been tracking the hidden problems there for a while, so we’re not too surprised. The top U.S. trading partner is finally starting to publicly face reality there. Today, China’s government announced it will be expanding its $586 billion stimulus plan. The market loved the news (kind of ironic how stimulus packages from the Chinese government have so much more credibility than ones from the U.S. government).
On the good side, China’s got a pile of money saved up for a rainy day. On the bad side, it’s raining very hard.
All of this just proves how uncertainty will remain strong for a while. As most investors have stressfully learned, uncertainty inevitably leads to volatility.
Cashing in on Volatility
The good news is you can turn all that volatility to your advantage. It’s ugly out there, and the markets are still whipsawing 2% or 3% every day. It’s volatile, really volatile.
But you can turn all the volatility into a buffer against losses. And you’ll also be padding your gains if the market does recover from here. And right now could be the best time to start doing it.
It’s called covered call writing. (There’s a way you don’t have to even deal with this strategy, I’ll explain how in a second)
Covered call writing normally requires you to buy at least 100 shares of stock. Then sell (or “write” in options-speak) the right to someone else to buy that stock from you at a predetermined price. You get a cash payment upfront (the premium) and the buyer of the call option gets the right to buy the shares from you.
If the stock goes up, they’ll buy it from you and pocket the difference as a profit. As a result, your upside is limited. If the stock goes down though, you have the cash payment to offset your losses. If it stays flat, you just collect the cash and keep the shares.
Covered call writing works well in a rising market. It doesn’t work in a rapidly falling market. It works great in a flat, highly volatile market.
During an average market with low to medium volatility, you’ll only get a 5% or 6% premium. During a bull market, you’ll get a 2% or 3% premium because volatility is so low. But during a highly volatile market, you’d get cash payments as high as 10% or 15% every month or two.
A One-Stop Covered Call Writing Shop
Now, if all this sounds a bit confusing, don’t worry. Covered call writing is a more advanced strategy that takes a bit of time and practice to do well. For those who don’t have the time or desire to learn how to do it, there’s a way to take advantage of this strategy.
In a way, you get all the benefits without having to buy shares and write a bunch of options. There are exchange traded funds (ETF) which do all the work for you.
One we’ve been waiting for the markets to level out on is the iPath CBOE S&P 500 BuyWrite Index (NYSE:BWV). This is a covered call writing ETF which does all the work for you. It owns the S&P 500 and writes call options against it. It collects the payments and buys the shares and pools all the funds. (Technically, it’s an Exchange Traded Note which essentially outsources all the trading activity – but you get the point)
In the chart below, you can see how the covered call strategy played out over the past 18 months (S&P 500 Index is red and BuyWrite Index Fund is blue):
The chart starts when the market peaked in October of 2007.
The S&P 500 has steadily declined since then. It’s down a bit over 50%.
Meanwhile, the covered call strategy has proved its worth. It’s down about 35%. And if you look back in time, right before the markets really started to drop last September, you’ll see the covered call ETF was flat while the S&P 500 was down by more than 10%.
Outlook is Great
It’s easy to see the value of covered call writing. Like I said, covered call writing works well in a rising market. It doesn’t work in a rapidly falling market. It works great in a flat, highly volatile market.
That’s why I’m starting to look at the strategy again now. Just take a look at what’s happening around us.
Steven Leuthold is advising clients to steer clear of his Grizzly Short Fund. A few months ago, Bill Fleckenstein, announced he would be closing down his short-selling fund. Fleckenstein said:
“The recent carnage in the stock market, real estate market, and the financial system (as well as the job losses) has washed away [the market] excesses to a large degree.”
This signals to me the short sellers are starting to run out of opportunities. In other words, stocks in general are reaching much more reasonable valuations.
On top of that, we’ve got to look at the trillions of dollars governments around the world are pumping into the system. As we discussed before with Harry Dent a few months back, this will likely spark a soft recovery – at least a temporary one.
This means we could be dealing with a relatively flat market for a while or a market which is starting to slowly turn around – at best. Volatility isn’t going away either.
These are the ideal conditions for covered call writing.
The markets are going to be a tough place for a while. Don’t let one up day fool you – especially one led by the “theory” China will be able to lead the world out of this recession.
There will be plenty of opportunity along the way. But, I warn you, it will only be those of us with the knowledge, focus, ideas, and the tools to take advantage of it all like the ones we routinely delve into here in the Prosperity Dispatch. Covered call writing, whether directly on individual stocks or through an ETF, will definitely be one of the tools you’ll want to have in your tool box.
By Andrew Mickey