Portfolio Revisions by Target, Trajectory and Strategy

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
10/31/2008	9.49
11/28/2008	9.10
12/26/2008	8.09
3/27/2009	8.53
7/31/2009	6.91
8/7/2009	6.71
8/14/2009	6.62
8/21/2009	6.56

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 (JBL), CTS Corp (CTS), TTM Technologies (TTMI), Vishay Intertechnology (VSH), Hutchinson Industries (HTCH), Western Digital (WDC), Seagate (STX), Adaptec (ADPT) and Pericom Semiconductors (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 (CRR), Lufkin Industries (LUFK), Humana (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 (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 (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 (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 (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 (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 (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

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.

Comments

[Ricard:]

Well, before I begin, thanks for posting your perspective for us to purview. I've come to appreciate the reasoning that backs up your trades.

I imagine you are posting this on a public blog to solicit opinions - at least, that is why I post my trades on SA.

Before I note my opinion, I apologize in advance if I seem a bit terse. I know I have a punctuated writing style that at times may be a bit abrasive. It must be my military background.

That being said, I think you are too optimistic. I also see some contradictions in the positions you have taken, or at least in your reasoning for some of those positions:


"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."

I do not understand how you can have the perspective of the S&P going to 1200 while noting that market activity 'suggest one or more sharp pullbacks between now and the end of next year'. Would it not follow to wait for the pullback before placing more bullish bets? And why bullish now, out of all times? Do you think this market is oversold?

Perhaps it stems from your view that defensive stocks will hold well in a pullback. Perhaps...but nearly all correlations have approached 1 the past year. Outside of gold, treasuries, and MCD and WMT, everything else tanked along with the financials. Even Wal-Mart is now showing cracks at the seams.

In the end, who knows? You may very well be right, and I may seem foolish for being so dense. Maybe the rising tide of inflation will make everything float again (nominally). Who knows...

Sep 01 01:15 AM

[Tom Armistead:]

My reason to post is to get feedback, and I appreciate your thoughtful comment, I see it as a challenge to be more logical in my thinking.

That got me looking at the relationship of the S&P 500 and unemployment. If in July 1982, when the S&P stood at 107.9 and unemployment stood at 9.8%, an investor had bought the index, his return by July 1983 would have been a gain of 50%. By then the S&P stood at 162.56, with unemployment at 9.4%. In late 1982 unemployment got as high as 10.8%.

The above is counterintuitive. But there is a historical precedent for large gains in the S&P 500 during a time when unemployment rates were very comparable to what we have now.

If we have learned anything during the past year it is that when various of these metrics that we use to measure investment and the economy go to extremes then the results are unpredictable.


On Sep 01 01:15 AM Ricard wrote:

> Well, before I begin, thanks for posting your perspective for us
> to purview. I've come to appreciate the reasoning that backs up your
> trades.
>
> I imagine you are posting this on a public blog to solicit opinions
> - at least, that is why I post my trades on SA.
>
> Before I note my opinion, I apologize in advance if I seem a bit
> terse. I know I have a punctuated writing style that at times may
> be a bit abrasive. It must be my military background.
>
> That being said, I think you are too optimistic. I also see some
> contradictions in the positions you have taken, or at least in your
> reasoning for some of those positions:
>
>
> "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."
>
> I do not understand how you can have the perspective of the S&P
> going to 1200 while noting that market activity 'suggest one or more
> sharp pullbacks between now and the end of next year'. Would it not
> follow to wait for the pullback before placing more bullish bets?
> And why bullish now, out of all times? Do you think this market is
> oversold?
>
> Perhaps it stems from your view that defensive stocks will hold well
> in a pullback. Perhaps...but nearly all correlations have approached
> 1 the past year. Outside of gold, treasuries, and MCD and WMT, everything
> else tanked along with the financials. Even Wal-Mart is now showing
> cracks at the seams.
>
> In the end, who knows? You may very well be right, and I may seem
> foolish for being so dense. Maybe the rising tide of inflation will
> make everything float again (nominally). Who knows...

Sep 02 07:18 AM

[Ricard:]

I also appreciate the time and patience you've displayed by not only writing a very detailed article, but also by responding in a calm and logical manner.

I suppose this would be an exercise in hegelian dialectics...let's see if we can reach a synthesis of ideas.

You've also likewise challenged me to look beyond my own 10 years of experience in the stock market and to look at a wider time frame.

I'd have to point out that you've picked the nadir in 1982 for making your argument. If the point was to pick a specific time of year, then you're on to something. But, if the point was to pick the nadir in the market and to compare it to continuing high unemployment rates, then for the purposes of this argument, I'd pick March 2009 and compare it to July 1982. In that sense, I'd make the argument that the market is overbought right now, and the rally upon which you're predicating your bullishness has already occurred.

Chart-wise, I'd liken today's market to July 1983, at the peak of that year's market, although I do not have the unemployment information handy to complete the comparison.

stockcharts.com/charts...

I'd also make the argument that the rally from 1982-1983 was much stronger and IMHO based on similarly strong fundamentals, which are missing in today's marketplace. In that sense, I'd continue with these basic assumptions and conclude that a correction, should it begin this Sept-Oct, will be much more severe than what occurred in 1983.

I understand that as it stands the basis for my arguments here are rather weak...I'd have to expound in greater detail or write my own article to fully develop this point. All I have right now is essentially a gut instinct based upon prolific reading of current economic conditions and comparisons made to Japan. I do at least have an article explaining my bearish stance going into 4Q:

seekingalpha.com/artic...

As I've yet to have any professional experience in finance, my current style relies more on persuasion than pure analytics. I'm firmly convinced that retail will surprise on the negative side this winter - barring any miraculous government intervention. My article essentially argues that this is due to 'borrowing' sales from the winter to fuel the summer rally, although the consensus seems to be that the consumer is weak enough as it is and doesn't need any additional assistance. I've backed that up by being more and more bearish in my trades as Q4 approaches.

Anyway, cheers, thanks for explaining your position.


On Sep 02 07:18 AM Tom Armistead wrote:

Sep 02 09:07 PM

[Ricard:]

PS - I fully agree with your two statements:

"If we have learned anything during the past year it is that when various of these metrics that we use to measure investment and the economy go to extremes then the results are unpredictable. "

...and that most successful trades are based upon counter-intuitive reasoning. P/E ratios can go up during a recession due to earnings being more volatile than market price, and the best time to buy is when the market is plunging off a cliff.

I can easily see and agree with the point you're making - that it's best to jump in BEFORE the employment picture actually improves and is priced in the market. I just happen to think that that trade happened back in March, although the opportunity may arise again in the near future.


On Sep 02 07:18 AM Tom Armistead wrote:

> My reason to post is to get feedback, and I appreciate your thoughtful
> comment, I see it as a challenge to be more logical in my thinking.

Sep 02 09:17 PM

[Tom Armistead:]

You have correctly identified March 2009 as the correct comparison point for July 1982. I also agree that fundamentals were better that year, the country was coming out of a recession that was more or less deliberately brought on in order to wring inflation out of the economy. By contrast, in 2009 the financial system is being propped by monetary and fiscal policy that may solve the immediate problems but have potential negative consequences down the road.

I read your article and I can see why you are looking for a 1987 type crash. I wouldn't discount it and obviously if that type of event were to occur there would be a lot of money to be made by having dry powder. But maybe it would be too much to look for two of those incidents in one year.








On Sep 02 09:17 PM Ricard wrote:

> PS - I fully agree with your two statements:
>
> "If we have learned anything during the past year it is that when
> various of these metrics that we use to measure investment and the
> economy go to extremes then the results are unpredictable. "
>
> ...and that most successful trades are based upon counter-intuitive
> reasoning. P/E ratios can go up during a recession due to earnings
> being more volatile than market price, and the best time to buy is
> when the market is plunging off a cliff.
>
> I can easily see and agree with the point you're making - that it's
> best to jump in BEFORE the employment picture actually improves and
> is priced in the market. I just happen to think that that trade happened
> back in March, although the opportunity may arise again in the near
> future.

Sep 03 11:38 AM