Despite the short-term "relief rally" that is likely to follow the debt ceiling agreement, we think investors should remain cautious due to the underlying economic headwinds that the U.S. continues to face. We think that the economy will continue to see subpar growth that will hinder the employment market and continue to create uncertainty. Current headwinds include:
- High levels of unemployment
- Weak housing market
- Subpar economic growth
- Continued risk of US credit rating downgrade
- Rolling European debt crisis
- Uneven growth rates in China
- Increasing cutbacks on state and local government spending
We continue to recommend that income investors should currently be overweight large capitalization, high quality dividend stocks. Large capitalization U.S. equities are moderately valued, garner decent dividend yields, and provide investors good protection against inflation.
In addition, given the continued uncertainty with the U.S. economy, we believe that investors should utilize a covered call strategy to generate additional income on their dividend portfolios.
Ideal Candidates for a Covered Call Strategy
In general, low beta dividend stocks in defensive sectors (consumer staples, health care, and utilities) are ideal for a covered call strategy. Stocks with low betas will tend to be less volatile than the general market and defensive stocks tend to hold up well in a market downturn. Since you are selling upside volatility with a covered call strategy, you want actual volatility to remain low after you overwrite a call on your dividend stock position. Low beta stocks are less likely to surge to the upside in a short term rally, making the probability of assignment lower.
Below are specific call options that we would recommend selling on some great covered call candidates. On average, the 6-month premium yield is 2.7%, with a margin of safety of 5.1%% and upside potential of 9.6%.