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Summary

  • The S&P 500 is now up over 185% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% correction.
  • Historically, market corrections happen approximately every 2 years on average.
  • We think that this rally is getting very long in the tooth and we wouldn't be surprised if we have a healthy pullback in the coming weeks or months.
  • Investors should consider a covered call strategy to help dampen portfolio volatility.

The S&P 500 (NYSEARCA:SPY) is now up over 185% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% correction.

As shown in the chart above, each of the major rallies over the past 15 years have been followed by a significant correction. This roller coaster has certainly taken a toll on most investors and many are just recently getting comfortable with the idea of holding stocks in their portfolio again. Note that the Nasdaq (NASDAQ:QQQ) and Russell 2000 (NYSEARCA:IWM) have rallied even more from their 2009 lows (253% and 229%, respectively).

However, now investors are feeling the full impact of fear and greed. On one hand, many investors fear missing out on future gains if this rally continues (especially if they missed out on most of the current rally). On the other hand, greed certainly rears its ugly head when investors are sitting on big gains and they don't want the fun to end.

Is a Correction Coming In 2014?

Most folks define a correction as a stock market decline of 10% or more and we haven't seen one in quite awhile. In fact, it has now been almost 3 years since the last 10% pullback. Historically, market corrections happen approximately every 2 years on average, but the million dollar question is… will we finally see one in 2014?

Even though the correction bandwagon seems to get louder every day, there have been much larger correction droughts historically. Since 1928, there have been 5 periods with correction gaps that were longer than the one that we are currently in. The record drought was 1,767 market days (from October 1990 to October 1997) and the second largest drought was 1,153 days (from March 2003 to October 2007), both of which occurred in the last 25 years. Basically, this tells us that a market correction won't necessarily be a self-fulfilling prophecy and that we shouldn't be surprised if stocks continues to chug along in 2014.

But what about current valuations? The S&P 500 is currently trading around 19 times trailing earnings (vs. an average multiple of 15.5x since 1871)! Again, history is littered with examples where above average P/E multiples were sustained for prolonged periods of time. In fact, during the last bull run (2003-2007), stocks spent more than a year trading north of 20 times earnings.

Bottom line is that none of us know when (or if) a correction will occur in 2014 and the best we can do is stick to our investment plan. We recently wrote an article highlighting a protective put strategy that will protect your capital if a major correction occurs. This article highlights a covered call strategy that will also help dampen portfolio volatility (with a focus specifically around dividend stocks).

The Components of Total Return

The total return on a dividend stock has two main components: (1) the dividend yield and (2) the change in stock price. Most of the time both of these components have a positive effect on your total return. However, a significant price decline can literally "wipe out" years of dividends, resulting in a negative total return.

The price fluctuation in a dividend stock cannot be ignored. While dividends have accounted for over 40% of the total annual return of the S&P 500 since 1926, almost 100% of the returns over the past 10 years were attributed to dividends (meaning the return on the underlying stock was negative).

That said, dividend stock investors that would like to enhance the yield on their investments (to help offset the potentially negative fluctuations in stock price) should consider implementing a covered call strategy.

A covered call strategy will add a third component to the total return of a dividend stock and will increase the probability that the investment will have a positive total return over time.

Covered Call Basics

Source: Options Industry Council

The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can hope to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed.

Ideal Candidates for a Covered Call Strategy

In general, low beta dividend stocks are ideal for option income strategies. Stocks with low betas will tend to be less volatile than the general market and should hold up relatively well in a market downturn. Since you are selling volatility with these strategies, you want actual volatility to remain low after you execute your strategy. Low beta stocks are less likely to surge (in either direction), making the probability of assignment lower.

For this analysis, we focused on stocks in sectors that hold up well in a slow-growth economic environment.

  • Health Care: Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE)
  • Consumer Staples: Altria (NYSE:MO), Philip Morris Intl (NYSE:PM)
  • Utilities: Southern Company (NYSE:SO)
  • Telecom: AT&T (NYSE:T)

Choosing the Right Strike

There are three key components to look at when choosing a strike price for a covered call strategy:

  • Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). The more volatile the stock, the higher the premium (i.e., the higher the risk). An investor should typically target a 1.5%-3.0% premium yield for options with 3-6 month expirations.
  • Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Note: If the underlying stock does not pay a dividend, the Margin of Safety will be equal to the Premium Yield. An investor should target a margin of safety of 3% or more (depending on the volatility of the stock).
  • Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. The more volatile the stock, the higher the expected upside profit. An investor should target at least a 4.5% upside profit potential for this strategy (which isn't bad for an 6-month return).

Note that investors could also consider writing an in-the-money call, which would maximize your premium yield but reduce your margin of safety. This should only be considered on stocks that you feel will be more volatile to the downside.

Generate Additional Income During a Market Downturn

Below are the specific call options that we would recommend selling on the candidates that we highlighted above. On average, the 4-6 month premium yield is 1.75%, with a margin of safety of 3.2% and upside potential of 5.5%.

(click to enlarge)

Summary

Although the covered call strategy can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

Source: Correction 2014: Take Cover