Take What the Market Gives You

The old saying economists have forecast nine of the past three recessions has been proven true time and time again.

It’s impossible to predict the future. There are so many variables to include. The variables are even greater in a global economy with billions of consumers, hundreds of governments, and technological developments making their way to the market every day.

That doesn’t stop them from trying though. The current predictions anticipate a recovery to come anytime between the second part of 2009 to a decade long depression.

Which one is right? Frankly, only time will tell. But merely complaining about how poor economists do at a relatively impossible task isn’t going to help us here. Only looking at how ridiculous the other side of the coin is will help us in this situation.

This is something that never made any sense to me. Every major economist’s prediction is pounced on, chewed up, and spat out by endless commentators and pundits. Everyone knows the track record of economists as a whole.

But when the stock market rallies, whoa boy, it’s always right.

We hear things like “the market is predicting a recovery” and “the markets discount the future and they’re discounting a recovery.”

If we cut through the noise and focus on reality, we’ll see a much different story. And it’s sticking to the facts and the reality which will ensure we survive and thrive regardless of which direction the market takes from here.

Stock Market Discounts

The stock market is just as bad as the economists.

If economists may have predicted nine of the last three recessions, the stock market has predicted nine of the last three recoveries.

Take a look at the chart below. It’s easy to see how bad an economist the stock market really is. There have been five bear market rallies of 10% or more since the U.S. economy fell into recession in November 2007:

Every rally gets bigger and bigger. Meanwhile, every economic indicator shows that things are pretty bad overall. But when the market is going up bad numbers are just “not as bad as expected.”

The market may be predicting a recovery. Then again, it has “predicted” four other times since the recession got started. So no one knows for sure what the market is telling us this time either.

That doesn’t mean we shouldn’t pay attention to the market. It does tell us a lot. Recently it told us stocks fell too far too fast. It also said there’s still too much cash on the sidelines which needs to come into the market. Most importantly though, it’s telling us things are still pretty bad out there (remember, the Dow is still down 44% from its 2007 highs) but, the world is not coming to an end.

It’s a tough time to be an investor. As we looked at last weekend, the noisemakers are running on high…

The framework for the next round of bank bailouts is in place (probably not the final one though). Wells Fargo just booked $3 billion in profits for the first quarter. Rumors are flying that 19 out of 19 banks passed the Treasury Department’s “stress tests” (which would be a surprise because the Treasury bureaucrats would be best suited to sink at least one bank so the test would be perceived as credible).

It’s not just signs of potential in the banks. Business inventories are falling. Housing sales have started to rebound.

I could go on and on, but you get the point. The market is taking news and putting a positive spin on it. As we’ve seen during many economic downturns before, this happens a lot and there’s no telling how much higher the market can go.

The next two weeks will be a major turning point. It’s earnings season and there will be high expectations for Citigroup (reports April 17th) and Bank of America (reports April 20th). If these two can beat already lofty expectations and if the “stress tests” results are viewed possibly, you can expect this rally to continue into the middle of spring.

For now, I expect reality to hit during the second and third quarters of earnings announcements. That’s three to six months away though, so I wouldn’t advise stepping in front of this bull market just yet (in other words, don’t short a rising market). But there is one thing you can do which allows you to stay protected against a downturn, ride this rally for almost all it has left, and come out ahead even if the market goes nowhere.

Take What the Market Gives You

Long time readers know I’m a pretty relaxed guy who tries to just take things as they come. Predict, prepare, and react, that’s one of the best ways to be successful at anything. Investing is no different. On the flip side, it’s exactly what makes investing successfully so challenging. Just take a look at what happened back in early March before this rally even started.

If you recall, we profiled some very strong words from Leuthold, one of the world’s most successful investors and manager of the wildly successful Grizzly Bear Fund, back in early March.

In an interview on Bloomberg TV, Leuthold said:

“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.”

Did you think Steven Leuthold was an idiot?

No one would fault you at the time. The major indices were hitting new lows. The Treasury Department was still without any semblance of a “plan.” Even Dr. Copper was forecasting an economic slowdown.

It was ugly. But we have to give him credit. When the “Grizzly Bear Turned Bullish”, we had to take note.

Of course, there was no need to jump into the markets. Not if you take what the markets give you.

And that’s what we looked at just a few days before this rally got started. We identified the lowest risk, highest reward way to catch the eventually rally. We found it in the iPath CBOE S&P 500 BuyWrite Index (NYSE:BWV).

The fund is a covered call writing fund. Covered call writing is a way to reduce your downside risk and provide high levels of current income. It’s a more advanced strategy, but one definitely worth learning (for more information on covered call writing, follow this link). We identified BWV as a way to automate the covered call writing process so we could enjoy all the benefits without having to set aside the time required to actively implement it.

That’s why I said BWV is one of the lowest risk, high reward ways to safely wade back into the markets. Throughout this downturn and sharp rally, it has been completely true.

The charts below show it all.

The BWV (blue line) has kept up pace with the S&P 500 index (red line) since this rally began.

Sure, it’s lagging behind by a few extra percentage points, but we expected that. After all, that small lag is the cost of a bit of insurance against a downturn which you can see the value of in the chart below.

This time, the difference in performance is much, much bigger. While the S&P 500 lost more than half its value, the BWV outpaced the index by nearly 20 percentage points.

A covered call writing ETF is certainly not a “fail safe” investment, but it does offer a lot more than individual stocks do. And that’s why I like it so much. It does almost as well during upturns and not nearly as badly during downturns.

And it is thinking like that, going the extra mile to uncover a unique opportunity, learn about it, put it to use effectively, and continue to search for more and better strategies which will make us all more successful investors. There will be plenty more to come “other than stocks” in the weeks and months ahead so we’ll be able to capitalize on any opportunity that presents itself.

This is a time when the market gives a lot, but only a few investors are able, willing, and prepared to take what the market gives us.

By Andrew Mickey

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