An Engineered Income Investing Top Idea:
On 2/21/20 the markets began a plunge into a deep correction. So far, this swoon has remained just above the 20% pullback, defining the official point that a bear market has been reached. Nonetheless, the threat of a bear lurks in the bushes.
My recent article discussed The Key Elements Of Risk Management. Today, I examine this bear market threat and show how you can plan for the likely deep bottom of any such bear market if it emerges, while locking in a 12% yield paid in cold hard cash right now to help you weather current and possible coming market downside volatility for the coming year.
Let's begin by looking at the trigger of this current market pullback. The prior market correction actually was a bear market. From an Oct. 2, 2018, high of $293.21, the SPY broad market ETF fell to a low of $233.76 on Dec. 26, 2018. It fully recovered from this 20.28% bear bottom by 4/23/19. From there, it rose a bit more and then consolidated in largely sideways movement around the $294 level through 10/10/19. Since that point, SPY rose sharply without any significant pause to a high of $339.08 reached on 2/19/20. That $45 (15.4%) unbroken strong bullish advance reflected a strong economy driving markets to resist all negative threats and deliver prices only supported by perfection going forward. A minor correction and consolidation was certainly due and would have been welcome.
Instead, news of spreading contagion by a new flu-like coronavirus (COVID-19) reached the point of significant disruption to critical Chinese supply chains. The unknown continuing disruption of these raw material and product sources tipped the broad market into free fall, plunging to deep correction levels 12.6% off the high in just one week. Since then, further decay has seen a test just short of a full 20% pullback to bear market trigger level.
So far, that 20% bear market threshold at $271 has held as support when tested twice on 3/9 and 3/10. While China industry does appear to be starting to get back to work, the picture of what extent the supply chain disruption has done and may still do to the global economy is unclear. Also unknown is if the COVID-19 virus will produce a second wave of contagion, reigniting quarantines and shutting down supply chains again. Also unknown is the extent that formal quarantines and public shunning of crowded spaces will have on global retail activity. Certainly travel, leisure, and transportation have been hit hard and will continue to be pressured for some time. The heavy debt leverage common in some of these sectors may trigger defaults that could yet trigger systemic threats to the banking system. In turn, any such pressure on the banking system could then spill over broadly to impair all economic sectors and activity. Although not likely from what's known and projected at this time, such events could create a shock far greater than the 2008/2009 global financial crisis (and at a time central banks have limited tools to deal with such a crisis).
For all these reasons, it's prudent to consider taking steps now to prepare for a possible coming deep bear market. As we can see from the downside volatility chart for the S&P 500 index, most bear markets see bottoms with 30% of less pull back from prior highs. Even the deepest bear markets of the past 50 years have seen a maximum pull back of 45%, except for the very brief deeper probe of the 2008/9 GFS bear market. Even that only had a few weeks below the 45% level. Certainly past history is no guarantee of future behavior, but it can give us a reasonable idea of targets for rational planning. A 45% draw back from the recent $339.08 SPY ETF market high would be $186.49. The far more typical 30% maximum bear bottom level would see $237 as the deep bear bottom for the most recent $339.08 high point.
I believe it's most likely that the current market headwinds of COVID-19 pandemic, with its supply chain and retail disruptions, coupled with the oil price war, will likely only drive a deep correction (as now being seen). This view expects the market, as reflected in SPY, to continue to trade in the $272 to $306 range. This broad and volatile consolidation may continue for six months as the globe learns to cope with the virus and adjust to oil volatility and a downside oil price in the $20s driving energy industry exploration and production planning. A look at the technical chart suggests that the $234 maximum bottom of the prior 2018/19 correction (really a flash bear market) is a rational target for maximum bear bottom potential of our current market.
We can use this analysis to act now, locking in a >12% yield and generating that cash return right now to help is ride out any such bear market for the next year. Consider writing (sell to open) the 373 day cash secured SPY puts for 3/19/21 $270 at a $29.69 premium, for a net covering cash of $240.31. This breakeven point puts us very close to the expected maximum bear market low (as discussed above). The premium provides an annualized yield rate 12.09% on net covering cash.
Risks include lost opportunity if markets recover and rise to generate more than a 12% in the coming year. It's a good risk to worry about a 12% guaranteed yield being insufficient to be considered a success. On the other hand, markets could decay and plunge further than the ~30% bear deep bear market bottom anticipated and protected by this trade idea. In such an event, there will be future opportunities to roll the position forward to gain more time for market recovery and/or to lower strike price at deeper protection levels. Alternately, if SPY units are presented at the $270 strike ($240.31 break-even level), you can begin writing covered calls at that $240 break even strike, generating even more option premium cash and driving your breakeven point ever lower.
Thanks for taking the time to read my work. Please share your comments and join further discussion of this thesis in the comment section. I consider that section an integral part of the article, providing important added discussion from both readers and myself.
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