The article introduction contains a brief overview of the series, links to more detailed explanations, and some reasons why I think now is the time to begin the hedging process.
Some more reasons why it is time to hedge. Things to think about.
Two new candidates are presented for consideration to use in the strategy.
The article concludes with a discussion of the risks of employing this strategy versus not being hedged.
In the first article of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process, and an example of how it can help grow both capital and income over the long term. In Part III, I provided a basic tutorial on options.
In this article, I will provide an explanation why I do not use ETFs or the respective put options. I will also provide two more candidate stocks to consider for use in this strategy.
I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: Select superior companies that have sustainable advantages, consistently rising dividends, and excellent long-term growth prospects. Then, I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets.
What could cause the next recession? In comments by FED Chair, Janet Yellen, she noted that "The recent flattening in housing activity could prove more protracted than currently expected," along with "heightened geopolitical tensions" and "financial stress in emerging markets." The housing concern may have partially been because new home sales plunged by 14.5 percent in March. I realize that January and February weather probably kept people from signing contracts that would close in March, but there was another problem that may explain the concern held by Ms. Yellen. According to this article from CNBC, "Regular, credit-dependent buyers are just not coming back to the market as fast as expected. In fact, the nation's home ownership rate fell to its lowest level in 19 years at 64.8 percent in the first quarter of this year, according to the U.S. Census. Household formation is also running at about half the rate it should be, given current demographics and pent-up demand." Along those same lines, mortgage applications have not been particularly strong which indicates future sales may dip further. Last week mortgage applications were up 5.7 percent, but during the week before applications were down 5.9 percent. And it was generally warm and sunny during both weeks. During the cold spell in February, applications hit near a 19 year low. We should be seeing a persistent rise in applications from that low point if the housing market is truly healthy.
On another front, weather did damage to the economy in the first quarter with the initially reported GDP growth rate coming in at a dismal 0.1 percent. The actual increase for the month was 0.0083 percent or basically flat. But the really big question is what will the revised numbers be? According to this article from the Washington Post, the answer is that the revisions will probably force the real number below zero to negative growth. One example of new numbers coming in the day after the report was issued:
"According to Macroeconomic Advisers' analysis, that means instead of the 0.2 percent boost in private nonresidential construction spending assumed in the GDP calculation, there was likely a 5.7 percent decline. Ouch."
That was based upon new data released on May 1st by the Census Bureau on construction that had not been included. In other words, we may already be in a recession, but that may not be reported officially until two months after the initial report for the second quarter GDP is made public. That would be at the end of September or early October.
We are already past the average duration of all bull markets since 1929. The current bull market has now surpassed in length all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, but experience tells me that we are probably within 18 months of when we will need to be protected. I do not enjoy writing about down markets, but the fact is: they happen. I don't mind being down by as much as 15 percent from time to time. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first and second articles of this series. Without that foundation, the rest of the articles in this series may not make sense and could sound more like speculating with options.
The next two candidates comes from the technology sector. Not all tech stocks get hammered during recessions, but many do; and some drop much more than others. Technology stocks generally carry much less debt, so those companies that carry significant debt often tend to be more volatile during economic downturns. Another reason that some tech stocks take a beating is that those companies are dependent upon corporations and governments to update technology periodically for sales. When a recession hits, many of those customers postpone investing in technology upgrades, especially on the hardware side, until the economy begins to improve. Thus, those tech companies that depend on those regular upgrades by such customers see revenues fall and margins contract. High beta stocks abound in this sector. Once again, it is really a matter of finding the weakest of those that tend to be the most cyclical in nature.
Hard drives for data storage is a commodity business now, but continues to have growth prospects due to the continuing surge in data creation and storage. However, it is also a very competitive industry where even the slightest advantage can lead to a significant swing in market share and revenue. Things have been relatively stable for a few years, but a recent event has set the stage for change. More on that in a moment.
Seagate Technologies (NASDAQ:STX) was involved in a leveraged buyout in 2000 during which the software portion of the company was sold. The new company went public in 2003 at $12 and rose to $31.80 later that same year only to fall back to $10.10 in 2004. The company's stock then climbed up to $28.90 at the top in 2007 and fell during the Great Recession to a low of $3.00 in 2009. Value Line lists the beta on STX as 1.35, while Yahoo Finance reports a beta of 3.1. Yahoo's calculation is the more current and reflects the most recent sell off in the stock. The stock performed extremely well (until recently) since late 2011, jumping up from $9.00 to a recent high of $62.76 achieved this January. The stock is currently trading at $49.28 (as of the close on May 8, 2014).
Seagate has a debt-to-capital ratio of 49 percent which is high for the tech sector, but it does have a strong cash position and has been paying down debt while also buying back shares. The dividend is currently $1.72 per share producing a yield of 3.4 percent. But the company cut its dividend in 2008 and then suspended the dividend in 2009 only to reinstate the dividend in 2010 at a higher level. The stock price reacted accordingly falling nearly 90 percent from the 2007 high to the low in 2009. Revenues fell, earnings turned into a loss, margins dropped, and capital investment fell. I see no reason to believe that results will improve significantly in the next recession.
We have already had a little taste of what can happen to STX if the market turns lower. STX has fallen by 25.5 percent in just over a month! I attribute much of this negative activity to a recent study by Backblaze which I came across in this article on Seeking Alpha. Whether the U.S. economy sinks into another recession or not, I have a hunch that STX stock is likely to fall some more as customers decide to seek a more reliable alternative. I expect that, during a recession, STX stock could easily fall below $20 a share, especially when the additional impact of the negative study results are included into the forecast. STX is likely to be forced to lower its price in a commodity business to retain customers. Alternatively, the company could attempt to retain its pricing which I would expect to result in a loss of market share. Either way, STX margins are likely to take a beating and the bottom line will suffer.
My preferred put option on STX is the January 2015 expiration contract with a strike price of $30 and selling for a premium of $0.45 per share (also as of the close on May 8, 2014). Each contract represents an option to sell 100 shares and will cost $45 (plus commissions). If the share price falls to $20 or less by January 2015, the potential gain is $955 per contract, or 2,122 percent. We need four contracts to provide approximately $3,820 of protection for a $100,000 portfolio for a total cost of $180 (plus commissions), or .18 or one percent of the total portfolio value.
If the price falls below $20 with several months left before expiration and we decided to unwind the hedge, we may not be able to capture 100 percent of the potential due to the extrinsic value (time value) that would remain. However, we would be able to capture most of the potential gain. Likewise, if the price falls below $30, but remains above $20 by the expiration date, we would only capture a portion of the potential gain. And it is always important to remember that if the price of the underlying STX stock remains above the $30 strike price through the expiration date, we may lose 100 percent of the amount invested in the options contracts as protection.
My next candidate company comes to us from the precision instruments industry (also within the tech sector), where revenues can be pushed into the future by customers when economic growth slows. Veeco Instruments (NASDAQ:VECO) makes LED and solar process equipment as well as data storage process equipment. Demand has been soft for VECO's product lines primarily due to overcapacity issues in China. The company has lost money for five straight quarters and the consensus is for a continuation probably through the third quarter of 2014. The hope for a light at the end of the tunnel has kept investors from leaving en masse so far, but another recession before the company returns to profitability could quell all hope for recovery and demolish the share price.
The share price fell 93 percent from a rationally exuberant level of $122.25 in 2000 down to $9.14 per share in 2002. The stock fell 76 percent from $22.25 in 2007 to $3.22 in 2009. The company does not pay a dividend and debt is minimal. But this is an extremely volatile stock when encountering a recession. Equipment orders can be delayed until demand catches up to capacity. Capacity is already an issue for VECO customers and the addition of a slowdown in global economic growth could push these shares off the edge. My target price for VECO shares in the next recession is $12. The current price on VECO shares is $32.50 (as of the market close on Thursday, May 8, 2014).
To take advantage of this situation, I like the VECO January 2015 put option with a strike price of $20 selling for a premium of $0.50 for a cost of $50 per contract (plus commissions). The spread between the bid and ask prices is enormous; bid $0.15 and ask $1.10. Thus, I decided to use the "last" price for the analysis. I recommend placing a limit order no higher than $0.60. But I would start with a bid of $0.50 or possibly lower. The reason is that the stock price has already fallen by 26.8 percent from the 52-week high of April 3, 2014.
The potential gain if VECO shares fall to my target is $750 per contract, or 1,500 percent ($20 - $12 = $8; $8 x 100 shares = $800; $800 - $50 = $750; $750 / $50 = 1,500%).
We need five contracts to protect $3,750 of portfolio value. This amount is exactly what we need to protect the $3,750 that represents 12.5 percent of a potential loss of 30 percent on a portfolio of $100,000. The total cost is $250 (plus commissions) or .25 of one percent for a $100,000 equity portfolio.
In fairness, I need to point out that there are more than one contract strike prices that will work for us on each of these companies. If you do not remember how to do the calculations, please go back and review the detailed explanation in Part II. For STX, you could also buy the January put option with a strike of $27 and good coverage with a 2,400 percent gain potential, assuming you get filled at the ask price of $0.28. Alternatively, you could go as high on the strike price as $37 and still get a decent return of 1,188 percent if you get the ask price of $1.32. All STX January 2015 put option contracts have ample open interest. You would need two contracts to cover approximately $3,136 of a loss. My problem with this contract is the cost. It would require 0.26 of one percent to cover 16 percent less than in my recommended contract. You may have different thoughts on that and are welcome to do what is best for your own peace of mind. On VECO, you can use the January put option with a strike at $23 to potentially achieve a return of 1,194 percent, assuming you are able to get filled at the last price of $0.85. I do not recommend using other strikes since the open interest is too low for my comfort. Everyone needs to find that strike price that feels right.
I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2015 all of our option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration in January 2016, using from three to five percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible.
Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent) to insure against losing a much larger portion of my capital (30 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins in 2014; but if the bull can sustain itself well into 2015, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues.
As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own put options on both companies as described in the article.