The Grateful Dead put it best: What a long, strange trip it’s been.
Despite major, myriad risks to the bullish narrative, including President Donald Trump’s impeachment proceedings and the on-again, off-again trade war with China, the equity market advanced to historic highs in 2019.
Even now, bearish concerns are so widespread that it’s hard to discuss stocks without someone citing a novella’s worth of reasons why the market is more likely to fall than rise from these lofty heights.
Yet stocks keep dancing around record highs, and the Cboe Volatility Index, or VIX, remains far below its long-term average of 19. The so-called fear gauge, currently around 14, is seemingly still telegraphing that investors have little to fear.
Regular readers will know that we largely discounted 2019’s risk factors, and we remain inclined to do the same in 2020. We have advocated selling cash-secured put options on blue-chip stocks that pay dividends, and using puts or call options for event-driven trading opportunities. (Puts increase in value when the underlying security price declines, while calls increase in value when it increases.)
The approach is an effective—if boring—way to manage money in a rising market by monetizing the fear of the doubters.
In a world in which most investors are always long stocks, downside puts are generally more expensive than merited. Investors overestimate the likelihood of declines, just as they underestimate the likelihood of advances. Indeed, there is a general sense emerging that the 2020 economy may slow, pressuring corporate earnings growth and overall stock prices.
Yet what is arguably the controlling market fact tends to be ignored because it is so simple: Low interest rates are great for stocks. When rates are low, investors invest. This is why emerging market debt—which exists at the riskier end of the risk curve—is popular. If rates were high and U.S. bonds paid 10%, emerging market debt would be as attractive as a cerebral hemorrhage.
If such reasoning resonates with you, take a look at the financial sector. The stocks are trading well, often near 52-week highs, despite concerns that bank profits would be hurt by low interest rates.
The Financial Select Sector SPDR exchange-traded fund (ticker: XLF) began pulling ahead of the market in early October. Since then, it is up about 17%, compared with about 10% for the S&P 500 index, as investors seek battered share prices and reasonable visibility on dividend increases. Each year, major banks ask the government for permission to buy back stock and hike dividends, which tends to juice returns.
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Investors who like the financial-sector setup can sell the Financial SPDR’s June $30 puts, which cost around $1.08 when the ETF was around $30.72. The selection of a six-month put with a strike price so close to the ETF’s share price demonstrates high conviction, which anyone who considers this trade must share. There is little margin for error with this trade.
If the ETF is below $30 at expiration, investors are obligated to buy it, meaning they would own many top financial stocks near their 52-week high price—or they must cover the put to avoid having to buy back the put at a higher price. If the ETF advances and is above the strike price at expiration, investors keep the put premium.
The cash-secured put strategy is intended as a way for investors to make use of the large cash positions that so many investors have amassed as they expect the market to tank. Rather than letting the money idle away in a money-market account, or worse, investors can use that money to back these put sales on quality stocks.
Some investors will criticize this approach, saying it is like picking up nickels in front of a steamroller, a phrase that is often used to dismiss such strategies. So far, though, picking up loads of nickels lying on the ground around blue-chip stocks that pay dividends has proven pretty profitable—and 2020 is off to a good start.
Email: editors@barrons.com
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