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Brendan O'Boyle
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Brendan, a Pennsylvanian by birth, completed his BS at Allegheny College and his Ph.D. at Stanford University in the field of organic synthesis. He has been employed by a major pharmaceutical company since graduation in 2009 and is an avid investor as well. His writings focus on a variety of... More
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  • Buy Gundlach's New DoubleLine Fund For Excess Returns

    The Shiller CAPE® ratio is a tool that determines whether the market is expensive or cheap relative to its normalized earnings. To determine the Shiller P/E, or CAPE, one takes the price and then divides by the normalized earnings over a given period (most often ten years). The lower the ratio, the cheaper the market and conversely the higher the expected return over a long-term time horizon. A new DoubleLine fund aims to capitalize on sectors of the market that are judged to be cheap by this metric.

    The Shiller Enhanced CAPE® Fund

    The Shiller Enhanced CAPE® Fund (MUTF:DSEEX) is a no-load mutual fund with a management fee of 0.45% and a net expense ratio of 1.09% (See Summary Prospectus). The fund gives investors 100% exposure to the four sectors of the S&P500 (NYSEARCA:SPY) determined to be cheapest by the CAPE ratio (Figure 1). Out of ten sectors, the bottom five are selected based on CAPE ratio and then one sector with the lowest momentum is omitted. The portfolio is then rebalanced monthly.

    Figure 1: The Shiller Enhanced CAPE Fund - Selective Sector Exposure (click to enlarge)

    Source: DSEEX Fact Sheet

    However, the manner in which the fund achieves stock market exposure is somewhat unique. Instead of passively buying equity exposure the fund instead achieves 100% equity exposure through the use of futures and/or swaps (Figure 2). This then leaves an additional 100% cash balance that is invested in a managed fixed income allocation. Effectively the fund has a 100% weighting in stocks and bonds. Clearly, this enhances the overall return, but with the potential disadvantage of interest rate risk.

    Figure 2: The Shiller Enhanced CAPE Fund - Equity And Fixed Income Exposure (click to enlarge)

    Source:DSEEX Fact Sheet

    Over a long time horizon this fund should generate outperformance for two primary reasons:

    First, the fund has additional exposure to bonds in addition to its equity exposure. The easiest way to visualize this is to imagine buying 100% exposure to the equity market and then investing with a 100% exposure to the bond market through the use of leverage. The primary disadvantage is interest rate risk, whereby the bond portion may fall and create capital loss through a period of rising interest rates. However, the fund will generate excess return in the form of coupon payments on the portion of the fund that is invested in bonds.

    Second, the fund should generate outperformance by investing in the sectors of the S&P500 most likely to outperform over the longer term based on cyclically adjusted P/E. Out of the ten sectors shown in Figure 1 only four will be bought. Over the longer-term these should outperform the overall market, however, there is concentration risk if these sectors do not outperform.

    Summary and Conclusions

    Mr. Gundlach recently made an appearance on Barron's explaining the strategy of his new DoubleLine fund. The strategy of this fund is clearly a bet on interest rates remaining fairly low, rather than a normalization of interest rates in the near term. A rapid rise in interest rates is probably the largest risk to the fund's strategy as bonds would underperform cash and stocks would also likely fall in such a scenario. Mr. Gundlach has made very well-timed calls in the recent past and he clearly believes now is an oppurtune time to invest. With investors clearly concerned over the recent rise in interest rates now may be a the moment to take a contrarian stance.

    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.

    Tags: SPY, long-ideas
    Dec 04 7:04 PM | Link | Comment!
  • What Does The Science Of Happiness Have To Teach Us About Owning Stocks?

    I just watched an outstanding TED talk by Daniel Gilbert, a professor of psychology at Harvard University, in which he discusses the science of happiness at some length. Watching this talk got me thinking about implications for investors in the stock market.

    First, it is necessary to define terms. Gilbert contrasts two forms of happiness in his talk; these are natural and synthetic happiness. Natural happiness comes from pursuing something that you desire and then getting it. For example, your goal could be to attend Harvard University and use your studies to pursue a coveted career. If this goal is within your power, then pursuing and accomplishing it will grant you natural happiness.

    Synthetic happiness, on the other hand, comes from being happy with what you get when you cannot control it. Perhaps your SAT scores and grades did not enable you to enroll at Harvard University, but you are willing to accept wherever you end up. Then you will experience synthetic happiness and this feeling of happiness could be just as real as the feeling of happiness from getting what you want. In general, we place far too many qualifications on things that must be accomplished in order to achieve happiness. Gilbert states that 90% of the time, achieving a major goal has little effect on our happiness only three months later.

    It must be noted that: Freedom is the friend of natural happiness, but it is the enemy of synthetic happiness. In other words, when you are in control you achieve natural happiness by pursuing what you want. However, when you are not in control you achieve synthetic happiness by accepting what you get. The resulting conclusion is that we must accept what we cannot change, while burdening ourselves only when it is within our power to accomplish something.

    Have you ever purchased something from a store and noticed that as long as you had the option to return it, you were never happy with what you had bought? For example, imagine you bought a video game, but you weren't sure if you wanted World of Warcraft or Donkey Kong. After reluctantly picking one at the store did you notice that as soon as you lost the option to return the game you stopped worrying about whether you had the right one, instead you were simply happy with what you had.

    In a similar fashion, investors in stocks can be in a constant state of nervous uncertainty. Perhaps an investment in Coca-Cola (NYSE:KO) isn't the best way to improve my long-term purchasing power; maybe I should invest in PepsiCo (NYSE:PEP) instead? Alternatively, maybe the whole market is overpriced or the economy is about to fall off a cliff. This uncertainty could lead to happiness if you were able to come to a certain conclusion about what to do. However, due to the uncertainty of the market, it is most often impossible to know what the correct action is, particularly over short time horizons.

    This leads to the conclusion that in order to maximize happiness investors should nearly always view the market as unpredictable and their investment decisions as unchangeable. It is only on rare occasions when asset prices are glaringly incorrect or the market is ignoring grave danger that an investor should take action by doing something.

    Consider Warren Buffett as an example. Amazingly, his great wealth is due in large part to a relatively small number of investment decisions. Importantly, these decisions were made at times when solid stocks such as Coca-Cola or American Express (NYSE:AXP) were so glaringly underpriced that he took action by buying them. The remaining time he viewed the market as unpredictable and as a result there was no reason to take any action at all.

    In a similar fashion, investors will achieve the maximum amount of happiness by viewing their past investment decisions as unchangeable for the vast majority of the time. Then they will simply be content and accept that the unpredictable nature of the market is not under their control. It is only on rare occasions that an investor needs to take any action at all.

    At this moment there are a reasonable number of modestly valued companies with good fundamentals that could be purchased immediately if an investor wishes to put money to work in the market. Companies such as: AFLAC (NYSE:AFL), Discover Financial Services (NYSE:DFS), International Business Machines (NYSE:IBM), Kinder Morgan Energy Partners (NYSE:KMP) and Exxon (NYSE:XOM) are all wonderful businesses trading at low valuations compared to what they have enjoyed historically.

    However, buying any one of these stocks today is not the only thing that must be done in order to be a successful investor. One must also hold the stocks until such a time when a rational decision would lead the investor to part with them. This decision could be due to valuation, business fundamentals or the macro economy, but it must be realized that many years could pass before the time to make this decision arrives. Until then the investor must be synthetically happy, realizing that the best kind of freedom is the freedom to do nothing at all.

    Disclosure: I am long AFL, DFS, IBM, KMP, XOM. 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: Some of the positions above consist of options derived from the underlying security.

    Jun 16 4:21 AM | Link | Comment!
  • Why Do Naked Puts Sound Risky While Covered Calls Seem Safe?

    I enjoy the terminology of the stock market. You have puts, calls, spreads, momentum, theta, beta, gamma and everything in between. But sometimes this terminology can be misleading, take the friendly sounding 'covered call' and compare it to the scary sounding 'naked put.' A covered call is like something your best friend in high school would promise you: "Don't worry man, I got you covered." While a naked put sounds like something strange and demeaning. I'm not going to elaborate here, use your imagination. Given this verbal dissimilarity, it would probably surprise you to know that writing a covered call and selling a naked put are nearly the exact same trade!

    Let's say I own the SPDR S&P 500 index fund (NYSEARCA:SPY), which trades for $152.11 per share. Then I sell a Jan-2014 call option with a strike price of $153 and a premium of $7.20. If I owned 100 shares of SPY to cover my call I would have spent $15,211 and collected $720 for the selling the option, a net cost of $144.91 per share. The graph below shows my theoretical gain and loss from the trade at expiration. If the market goes up it does not matter how much, I will earn a profit of $8.09 (the premium plus the amount the option was out of the money) or 5.58% on the $14,491 I had put at risk to enter the trade.

    Figure 1: Hypothetical Gain and Loss from Writing a Covered Call

    But what if I set up the exact same trade through selling a put instead? A $152 strike Jan-2014 put sells for $10.18. Let's say I had the cash to make the purchase, but I wanted a lower my entry price. I don't want to chase the market higher, but I don't want to sit in cash in the meantime. So I sell the put mentioned above and I collect $1018, I must have $14,182 in cash to cover the trade, but now I hold $15,200 in cash. What is my gain or loss on the trade? Again the SPY must trade down squeezing my profit until at $141.82 I am just breaking even. Below that price all the downside is mine to bear. In this case I have risked $14,182 and been paid $1018 for my trouble or 7.17%.

    So which is the safer trade? Selling a naked put is the superior trade because the breakeven price is lower and the profit on at risk capital is higher. Now some of you may be thinking: what about the return from dividends I would receive for holding SPY? The last quarterly dividend for SPY was $1.02 or $4.08 annually. However, this yield is only 2% and I already established that I would be holding $15,200 in case my puts are executed. There are any number of very conservative fixed income funds that will pay an equal amount relative to the dividend yield of SPY, thus the issue of dividends is moot.

    The major difference between writing a covered call and selling a naked put is that through holding the stock you are able to collect the dividend in the meantime. Thus, covered calls can be an effective way to collect an added premium in addition to the dividend. However, it must be noted that this is not a free lunch; the holder of the stock retains all the downside, just as the seller of a put does. Imagine that I practiced a covered call strategy for the SPY each year since 2000 and assume the premium is the same relative to what it is now (unfortunately I do not have access to historical options data).

    If on the first of January each year since 2000 you entered a covered call trade you would have lost 23% of your capital. You realize a small gain if the market goes up, but at the expense of a large loss if the market goes down. Of course selling puts would have the same disadvantage if as soon as the shares were assigned you sold for a loss and opened another trade. However, since the premium paid for the put is higher executing this strategy would have lost approximately 7% of your capital rather than 23%. Both exclude dividends, but the put strategy would have outperformed in this regard since the yield on a risk free bond exceeded the dividend yield of the S&P 500 over this time period.

    Table 1: Hypothetical Return for Selling a Yearly Put or Writing a Covered Call with Annual Rebalancing of the Trade (click to enlarge)

    Several conclusions are important:

    1. Whether you are selling a put or writing a covered call the goal must be to continue hold the stock if the put is exercised or if the call expires worthless. Both strategies simply serve to lower your entry price.
    2. Selling naked puts is less risky because the higher premium lowers your entry point more. A lower entry point is safer.
    3. The major difference between the approaches is the covered call captures the dividend. This can be a reasonable strategy, but my preference would be to put the strike price deeper in the money. This lowers your cost-basis more if the call expires worthless and you experience a loss.

    Conclusions:

    While a covered call strategy can be viable for stocks paying high dividends, it is generally inferior to selling naked puts. This is because the premium paid for a put now significantly exceeds that of a call as the above example for SPY illustrates. While writing covered calls for high dividend paying stocks, such as AT&T (NYSE:T) can be attractive, the incredibly low premiums for these calls mean that there is still significant risk. For example, in order for an AT&T call to have time value the lowest strike price Jan-2014 call available is $35 for a premium of $2.15. The $1.14 time value means the owner will not execute in the near term and you can expect to collect the dividend, however, you will have all the risk should the stock fall below $33.85. Over one year assuming the trade began before the first quarter ex-dividend date, the maximum upside will be 4 quarterly dividends of $0.45 plus the time premium when the contract is executed or $2.95 total. Thus, the maximum gain is 8.7% and because you collected four dividends your cost basis if the call expires worthless is $32.05 representing a buffer of 11%. Thus for high dividend stocks the covered call strategy can be viable because collecting the dividend over time reduces your risk and adds to the potential return.

    In many cases these incredibly low time values for LEAP calls on dividend paying stocks make purchasing calls very attractive. Stocks that have cheap LEAP calls include: ConAgra Foods (NYSE:CAG), General Mills (NYSE:GIS), Johnson & Johnson (NYSE:JNJ) and Exxon Mobil (NYSE:XOM). This strategy is even more attractive if the company is presently repurchasing stock as holder of the call option stands to pocket all the upside felt from a shrinking share count.

    As shown above, the covered call strategy is friendly in name only. Premiums are so low relative to puts that selling naked puts is more attractive at the present time. Furthermore, holding stock an unpaired trade is less risky as the past twelve years have illustrated. At least if the market continues to go up you have something to gain, once you sell your upside you have a small known gain, but a large potential loss. It may feel good to collect a premium, but over time that small premium is not adequetely protecting you against years when the market declines.

    In many cases names can be deceiving and this is certainly the case for covered calls, as the recent past has shown they are far riskier than most investors believe them to be.

    Disclosure: I am long CAG, GIS, JNJ, T, XOM. 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: For CAG, GIS, JNJ and XOM I am long LEAP calls, while for T I own shares but I am short LEAP calls.

    Tags: CAG, GIS, JNJ, T, XOM, SPY, options
    Mar 04 10:32 AM | Link | Comment!
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