Income Inequality And The Search For Yield

by: Michael Thomas

Summary

Income inequality is as important a gauge of economic health as it is a social issue.

Chasing yield can be a very dangerous game, especially in an inflated market environment.

Options can be used to increase yield and help manage levels of acceptable risk.

Income Inequality

Both the Republican and Democratic primaries in the United States have put on display a wide array of controversial topics involving the nation's challenges with immigration, trade, and Constitutional amendment rights, just to name a few. Perhaps none of the issues are felt by more Americans than that of growing income inequality, an issue that Bernie Sanders made a pillar of his campaign. As the extremely wealthy continue to gobble up larger and larger portions of the national income, the average Joe is left trying to figure out how to compensate for a shrinking slice of the national pie. Adding to the challenge are stagnant wages and low risk-free interest rates making it more difficult to save and provide investment income.

Gini Ratio Chart Click to enlarge

The Gini ratio provides a measure for income inequality with 0 representing absolute income equality and 1 representing a single person receiving all available income. As the chart above clearly demonstrates, income inequality has been steadily increasing. Of course perfect income equality isn't possible, nor likely desirable, as people need incentives to work harder and require compensation for doing more than their neighbors. A certain level of income inequality is unavoidable. The problem arises when levels get too high and the middle class begins to be left behind.

Click to enlarge

Taking a slightly different view of income inequality and looking at the top 10% of income recipients provides some valuable insights. The chart above reveals that peak levels of income inequality also happen to mark the beginnings of two of the worst economic periods seen in United States history. The Great Depression preceded by the 1929 stock market crash was also preceded by a peak level of almost 50% of national income going to the top 10%. Fast forward to the Great Recession preceded by the crash of 2008 and the same level is found.

The fact that peak levels of income inequality preceded two of the worst economic periods in United States history probably isn't coincidental. It seems logical that when a smaller amount of income is distributed to the majority of the population aggregate demand will suffer. After all, how much money can one person possibly spend? Aggregate consumption invariably falls when larger amounts of money enter fewer hands and can lead to economic downturn. Bad things tend to happen when the majority of the population no longer has the means to maintain demand for the current level of goods being produced, like deflation.

Does this mean that extremely wealthy investors like Warren Buffett are bad? Well the answer is yes and no. Buffett is often viewed with great admiration for all that he has accomplished and rightly so. His investment philosophy is also followed by many, again rightly so. But is he good for the overall economy? Probably not. One of Buffett's well known traits is that regardless of amassing wealth in excess of $65 billion he remains frugal in daily life. Is this admirable for someone worth $65 billion or is it just plain bad for the economy as a whole? You decide.

Trying To Keep Pace

Given the challenging environment faced by average investors these days, creative ways to enhance yield become very important. Central banks responded to the most recent financial crisis by destroying the safest way to save for the future, rendering government treasuries practically useless when accounting for inflation. Granted they also have enjoyed a nice price run for several decades leading to substantial capital gains, we're at a point where it's a game of chicken between investors and the Fed. Counting on continued capital gains from diving yields is riskier now than ever, even as the amount of sovereign debt around the world with negative interest rates builds.

Obvious ways to try and get ahead of the curve are investing as early and as often as possible. Investing in quality dividend paying companies with histories of increasing annual dividends is a very sound investment philosophy. One of the main reasons behind this is the effect of compounding and earning interest on interest. However, it takes time for this strategy to pay "dividends." Not everyone may have the luxury of youth and need to find other ways to compensate for time.

I recently unveiled a new public portfolio termed "The Most Boring Stock Portfolio on Earth", which was designed to increase the pace of compounding and also allow for more of a "take what the market is willing to give you" approach. The strategy uses quality dividend paying stocks as a foundation and makes use of options which allows for faster reinvestment of capital. The methodology behind the portfolio is outlined in detail in the link provided above and the current positions are presented below.

The Most Boring Stock Portfolio on Earth

Company Name Ticker Industry Put Strike Expiration Date Date Sold Option Length (days) Premium Received Option Requirement Annualized Yield Position Weight Current Stock Price Option Moneyness
BOK Financial Corp BOKF Banks $45 09/16/16 06/13/16 95 $49.34 $4,500.00 4.28% 4.07% $58.87 23.56%
CSX Corp CSX Transportation & Logistics $22 11/18/16 06/13/16 158 $42.34 $2,200.00 4.50% 1.99% $25.67 14.30%
United Technologies Corp UTX Aerospace & Defense $85 11/18/16 06/13/16 158 $116.34 $8,500.00 3.19% 7.69% $100.62 15.52%
Yum Brands Inc YUM Restaurants $65 10/21/16 06/13/16 130 $78.34 $6,500.00 3.42% 5.88% $83.04 21.72%
Ryder System Inc R Consulting & Outsourcing $45 11/18/16 06/13/16 158 $69.34 $4,500.00 3.60% 4.07% $60.53 25.66%
Fastenal Co FAST Industrial Distribution $37 11/18/16 06/13/16 158 $99.34 $3,700.00 6.31% 3.35% $44.38 16.63%
DeVry Education Group Inc DV Education $15 11/18/16 06/13/16 158 $135.34 $1,500.00 22.09% 1.36% $18.23 17.72%
VF Corp VFC Manufacturing - Apparel & Furniture $58 11/18/16 06/13/16 158 $199.34 $5,750.00 8.19% 5.20% $60.76 5.37%
Infinity Property & Casualty Corp IPCC Insurance - Property & Casualty $75 12/16/16 06/13/16 186 $294.34 $7,500.00 7.85% 6.78% $80.74 7.11%
Qualcomm Inc QCOM Communication Equipment $45 10/21/16 06/13/16 130 $76.34 $4,500.00 4.84% 4.07% $51.94 13.36%
T. Rowe Price Group Inc TROW Asset Management $65 10/21/16 06/13/16 130 $159.34 $6,500.00 7.04% 5.88% $71.35 8.90%
Polaris Industries Inc PII Autos $70 09/16/16 06/13/16 95 $219.34 $7,000.00 12.59% 6.33% $82.66 15.32%
Williams-Sonoma Inc WSM Retail - Apparel & Specialty $48 11/18/16 06/13/16 158 $314.34 $4,750.00 15.95% 4.30% $51.13 7.10%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/13/16 130 $14.34 $500.00 8.26% 0.45% $6.37 21.51%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/14/16 129 $67.96 $1,500.00 13.36% 1.36% $6.37 21.51%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/16/16 127 $43.65 $1,000.00 13.06% 0.90% $6.37 21.51%
Gap Inc GPS Retail - Apparel & Specialty $17 12/16/16 06/13/16 186 $135.34 $1,700.00 16.22% 1.54% $21.27 20.08%
ONEOK Partners LP OKS Oil & Gas - Midstream $21 10/21/16 06/14/16 129 $24.34 $2,100.00 3.31% 1.90% $40.06 47.58%
Analog Devices Inc ADI Semiconductors $48 09/16/16 06/14/16 94 $49.34 $4,750.00 4.09% 4.30% $55.36 14.20%
Flowers Foods Inc FLO Consumer Packaged Goods $15 10/21/16 06/14/16 129 $24.34 $1,500.00 4.66% 1.36% $18.27 17.90%
Brinker International Inc EAT Restaurants $40 10/21/16 06/14/16 129 $89.34 $4,000.00 6.45% 3.62% $46.41 13.81%
Tiffany & Co TIF Retail - Apparel & Specialty $60 11/18/16 06/13/16 158 $294.34 $6,000.00 11.70% 5.43% $59.16 -1.42%
AmTrust Financial Services Inc AFSI Insurance - Property & Casualty $24 09/16/16 06/13/16 95 $84.34 $2,375.00 14.35% 2.15% $24.30 2.26%
Bunge Ltd BG Consumer Packaged Goods $50 10/21/16 06/16/16 127 $84.34 $5,000.00 4.92% 4.52% $57.76 13.43%
Dominion Resources Inc D Utilities - Regulated $63 10/21/16 06/16/16 127 $54.34 $6,250.00 2.52% 5.65% $78.43 20.31%
Target Corp TGT Retail - Defensive $65 10/21/16 06/13/16 130 $257.34 $6,500.00 11.52% 5.88% $69.74 6.80%
TOTALS 138 $3,076.77 $110,575.00 7.52% 100.00% 13.93%
Click to enlarge

The portfolio makes use of selling put options to achieve an average annualized yield from option premium of 7.5% while providing a contingent claim to someone else to buy their shares at an average of 14% below current stock prices. The roughly $3,000 in option premium received from selling the put contracts was immediately available for use to reinvest.

Conclusion

Whomever originally came up with the idea to make money with money inevitably destined us to have the financial system we live with today. To take the leap from using money simply as an easier method of exchanging goods to lending at interest to others may have been the largest leap in the history of mankind. Obviously, it benefited those that had the money to lend in the first place. Like it or not, it's here and average investors have to continue to find ways to navigate the increasingly dangerous patterns of boom and bust cycles it creates while not losing their shirts. Options can help.

As an investor, it's always important to make sure your toolbox includes all of the tools available on the market today and options can play an important role in portfolio management. Although they can often be deemed as extremely risky, it's all in how they are used. The strategy employed in my portfolio, for example, makes no use of leverage thereby eliminating one of the riskiest aspects of using them. Even if you have never used options in the past it is a worthwhile endeavor to learn how they work and if they are appropriate to use in your own portfolio.

Disclosure: I am/we are short PUT OPTIONS IN ALL STOCKS MENTIONED.

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.