Safely Position Yourself for a Rally with the iPath Covered Call Writing ETF

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:

Stock Market “Predicts” Recovery
Period	S&P 500 Increase
3/10/08 – 5/19/08	12.0%
10/10/08 – 10/13/08	11.6%
10/27/08 – 11/04/08	18.5%
11/20/08 – 01/06/09	24.2%
03/09/09 -?	?

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 (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.

click to enlarge

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. Readers of the Prosperity Dispatch will be.

Comments

[whidbey:]

Cetin
I am not impressed with your statistic on sustained selling being rare. You doubtlessly have heard that nothing surges forever, disregard for bad news not withstanding. The worry is justified so take heed.

Apr 13 06:07 PM

[mavericks:]

A little advice. Forget about BWV and write calls yourself on DIA or SPY. OR better yet...buy some discounted CEF's that also use a buy-write strategy, are at significant discounts AND pay monthly. EOS and EOI come to mind. DPD and DPO are a couple more but they have moved up to premiums and I would wait. There are many quarterly pay buy/write CEF's at significant discounts too.

Apr 14 12:07 PM

[j'adoube:]

This is an ETN, not an ETF.

Please know the difference.

Apr 14 02:13 PM

[granger:]

Is there a put write fund?

if so which is better? put or call writing funds

does the type of market dictate which to use?

Apr 16 04:35 PM

[granger:]

Yes, I currently own a portfolio of individual stocks

I actively write calls against my positions for income and protect using puts

My question is in regards to broad market exposure. I generally stay away from ETF's and mutual funds, preferring individual equities. But, there are times where I fill gaps or want broad exposure quickly, and use either S&P call options or Broad Market ETF.

I was just wondering in uncertain times if these might be better for broad exposure and which market conditions would favor them.




On Apr 17 02:41 PM Freya wrote:

> granger: do you own optional stocks?
>
> If you do, and believe they are overpriced, write Calls on them,
> out of the money.
>
> If you have cash available, would like to buy but are afraid. Buy
> the stock and a married put.
>
> Both of the funds you describe mean you are unwilling or are afraid
> but want income. Find some nice PFDs or a corporate Bond fund, cut
> out the middle man. Go PIMCO or some such.

Apr 18 03:15 AM

[Freya:]

granger: do you own optional stocks?

If you do, and believe they are overpriced, write Calls on them, out of the money.

If you have cash available, would like to buy but are afraid. Buy the stock and a married put.

Both of the funds you describe mean you are unwilling or are afraid but want income. Find some nice PFDs or a corporate Bond fund, cut out the middle man. Go PIMCO or some such.

Apr 17 02:41 PM

[Freya:]

whidbey: the opposite is also true, nothing drops forever. Bull Markets are known to begin from what Investors initially believe are just "oversold" rallies.

And VV as the chart in the article indcates.

But the longer this Rally lasts, the more impressed I am. Time wise it has exceeded every previous rally except the first. The move has involved all sectors and is Worldwide.

Time will tell but the current activity appears to be alleviating the Over Bought condition.

To me, it is a Gift Horse. I'm not going to look in its mouth. Having said that, I've added FAZ and SDS just in case.

Apr 15 03:08 AM