Portfolio Revisions by Target, Trajectory and Strategy

Includes: COP, EXC, NKE, PG, UTX, XOM
by: Tom Armistead

Over the past several weeks, I have been changing the emphasis of my portfolio, based on four considerations: 1) target level for the S&P 500; 2) possible trajectory (smooth or jagged); 3) long term interest rates' and 4) future implied volatility. This essay briefly covers each point, going on from there to discuss a shift in strategic emphasis.

S&P 500 Target – I am investing in ways that will be profitable if the S&P 500 hits 1,200 by 12/31/2010. In July I did a study on Corporate Profits as reflected in GDP, postulating a relationship between that data and the S&P 500 index on a quarterly basis. Based on that line of thinking the 1,200 target seems reasonable.

If the index is to go from 1,030 to 1,200 between now and December 2010, it will return 11.5% annualized. Excellent returns are possible by owning US equities during this time period.

Trajectory – It is difficult to believe that the markets will rise steadily over any protracted period. The current questionable market activity, low volume, sudden demand for troubled financials and possibility of economic aftershocks suggest one or more sharp pullbacks between now and the end of next year.

With that in mind, right now I'm around 30% cash. Stocks underlying various covered calls will soon be called away, adding to cash on hand.

Interest rates – the Fed “continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” As financial stability becomes more assured, treasury yields may not seem attractive and the normal relationship of corporate bond yields and equity P/Es to treasuries may be restored. Baa corporate bond yields are in free-fall, suggesting a substantial return of confidence in the debt markets. The high rates were a symptom of the crisis of confidence that hammered the markets and the rapid improvement is a favorable sign.

Corporate Baa Bond rates, weekly, per Fed

















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Volatility – commentators have noted that the historical volatility of the S&P 500 index has been running less than implied volatility. The VIX has been spending some time under 25. Before the trouble hit it went on for months between 12 and 18. Noting that the credit fears which drove the crisis are abating, volatility generally may decline along similar lines.

Options strategies that attempt to take advantage of high volatility are becoming less attractive, although there would be some opportunities in the event of a serious correction with consequent temporary spikes in volatility.

Strategy – leading up to the March meltdown, and until recently, much of my investment activity has been focused on beaten down tech stocks, mostly smaller cap and with strong balance sheets. Stocks we've written up here on SA included Jabil Circuit (NYSE:JBL), CTS Corp (NYSE:CTS), TTM Technologies (NASDAQ:TTMI), Vishay Intertechnology (NYSE:VSH), Hutchinson Industries (NASDAQ:HTCH), Western Digital (NYSE:WDC), Seagate (NASDAQ:STX), Adaptec (NYSE:ADPT) and Pericom Semiconductors (NASDAQ:PSEM). I have been scaling out of these picks steadily since May, going from all in to as high as 35% cash. Profits were heartwarming. Options strategies were driven by combinations of value and high volatility and consisted primarily of covered strangles as written up on Carbo Ceramics (NYSE:CRR), Lufkin Industries (NASDAQ:LUFK), Humana (NYSE:HUM) and the like.

The easy money has been made on small tech- and volatility-based options strategies. Going forward, with interest rates low and business conditions uncertain, large, well-capitalized and relatively steady performers will command a premium. Reduced volatility makes it attractive to buy options, primarily deep in the money LEAPS expiring in January of 2011. These provide leverage at an affordable premium. Writing short term calls, close to the money over these positions, attractive returns are possible, like covered calls on steroids. If successful in the aggregate they will outperform the 11.5% projected for holding the S&P 500 index. The strategy performs well in a sideways or upward trending market.

Leverage increases the downside risk substantially. However, based on experience during the meltdown, I don't believe this objection is as serious as it looks at first glance, especially if the stocks selected are defensive. Holding cash in reserve, LEAPs can be used as a substitute for owning the shares. If the market takes a dip, the assumption is that it will recover. If the situation on the individual stock changes, the trade has to be re-examined.

Trades – here is a listing of new positions over the past two weeks. I adjusted the sizes shown to fit my risk tolerance and position limits.

Exxon Mobil (NYSE:XOM), share price 66.49 when executed

Buy to open 10 ODUAK, XOM Jan2011 55 calls @ 14.50

Sell to open 10 XOMAN, XOM Jan2010 70 calls @ 2.92

United Technologies (NYSE:UTX), share price 59.xx when executed

Buy to open 10 VXUAJ, UTX Jan2011 50 calls @ 13.30

Sell to open 10 UTXKL, UTX Nov09 60 calls @ 3.00

Procter & Gamble (NYSE:PG), share price 53.56 when executed

Buy to open 10 VPGAI, PG Jan2011 45 calls @ 10.50

Sell to open 10 PGAK, PG Jan2010 55 calls @ 2.20

Exelon Corporation (NYSE:EXC), share price 51.19 when executed

Buy to open 10 VFRAG, EXC Jan2011 35 calls @ 17.20

Sell to open 10 EXCAK, EXC Jan2010 55 calls @ 2.05

Nike Inc (NYSE:NKE), share price 56.02 when executed

Buy to open 10 VNKAH, NKE Jan2011 30 calls @ 17.90

Sell to open 10 NKEAL. NKE Jan2010 60 calls @ 2.40

ConocoPhillips (NYSE:COP), share price 44.xx when executed

Buy to open 10 OJPAF, COP Jan2011 30 calls @ 15.45

Sell to open 10 COPAI, COP Jan2010 45 calls @ 3.25

Click to enlarge

Most of the companies involved are heavily followed by professional analysts. Rather than do complete write-ups on each, I will be insta-blogging them, short discussions of why I see value and the rationale for the options strategy employed.

Unemployment – the wild card here. Washington will probably extend benefits enough to mitigate the effect on the economy. Market moves beyond S&P 1,200 seem unlikely until major gains are made on employment.

Disclosure: Net long COP, NKE, EXC, PG, UTX, XOM and HUM. Reducing CRR, LUFK, JBL, VSH and HTCH. Short STX. No positions in the other stocks mentioned.