Weekly Recap & Outlook – 10.09.09

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Capital Markets Recap

Unlike my career options, stock options look attractive.  In client portfolios, we continue to find value in utilizing them in the context of covered calls, the most elementary of all option strategies, but the strategy fits with a by-hook-or-by-crook approach to generating portfolio returns.  The most frequent use of these for us is in a scenario where a stock we’ve bought appreciates nicely, to a point where we wouldn’t mind just pocketing our gains and a little premium income.  If the option gets exercised we give up the stock; if not, we keep the option premium and the stock, happy with either alternative. 

A less frequent approach is referred to as a buy-write strategy. It involves buying a stock and simultaneously selling a call option on the position.  In that case, we’re happiest if the option gets exercised and we give up the stock, since it results in an enormous return.  Here’s an example of one that’s presently available and attractive.

Teck Resources (TCK) is a diversified miner, pulling out of the ground all those things from your high school chemistry class, like niobium, copper, lead, and other assorted heavy stuff.  It’s presently selling for $31.48.  Call options with a strike (exercise) price of $35, expiring in November, sell for $1.25. 

  1. That’s 4.01% of the stock price.  There’s 43 days until expiration, so in terms of the bank’s CDs, that’s a 33.59% APY (not FDIC insured, blah, blah, blah).
  2. Plus there’s $3.84 of upside to the strike price, which amounts to 12.32% of the stock price, or a 103.17% APY (!). 
  3. Put the two together, and the return for the period is 16.34%, or a stupid 136.76% annualized return.

Naturally, this sort of strategy is best engaged in with the help of a trained professional, and you’ll be the first to know when we’ve spotted one.  Don’t consider this to be a recommendation, and don’t weld without a helmet.  Call options should only be sold on positions you’re happy to let go.  Option premiums are not free money.

A search of call options with similar return characteristics and the qualifier of 100% annualized returns or greater produces 28 stock/option combos.  Those are companies larger than $2 billion, the vast majority of which are priced at $25 and higher.  In short, these are solid companies, something you need to be mindful of lest the option is not exercised.

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Markets are up sharply this week, as of 3:14 today, and it’s not Beta related; almost all equity markets are up in like fashion.  Bonds have backed up on Bernanke’s jawboning about monetary policy (below) and the dollar’s up today for the same reason (higher rates = stronger currency).  Gold’s back above $1,000, but there’s some technical weakness in the metal.  $1,000 should continue to be an important level, and it should be some time before its firmly in the past.

Here are a couple of quick thoughts on markets and their trajectories.  I’ve lifted this first point from Barry Ritholz’s blog, but it’s certainly not thinking that’s unique to him–we’ve contemplated this ourselves:  this rally is hated.  Seemingly everyone expects it to end, from market strategists who have been wrong to the proverbial shoeshine-boy types.  For example, the October 2-8 Fort Wayne  Business Weekly featured a letter to the editor by Jacob Benedict, an “analyst at AMI Investment Management,” who essentially tries to talk the market out of its rally.  As Barry pointed out, rallies don’t end because/when they’re hated; they end when they’re loved.

Joe Granville is an old guy.  In the world of investments he’s up there.  His letter (still faxed) of today included the following:

A number of prominent Wall Streeters were looking for a crash in September and October.  I said if they could be proven wrong in October then the market for the rest of the year would belong to the bulls.

Tomorrow is the two-year anniversary of Dow 14164.63. It was on October 9, 2007, that I announced here that we are seeing a terminal blowoff in the Dow [got credibility yet?].  Now with equal conviction my numbers see a rising market ahead for the next two years or longer.

Top Stories

  •  Alcoa kicked off the third quarter earnings season as it usually does with a surprising profit of $0.32/share, compared to $0.07/share in Q2.   The company referred to its markets as “stabilizing,” and said that it expected low inventory levels to boost second half aluminum consumption to 11%.
  • Also in the category of earnings, once-upon-a-time fertilizer darling Mosaic saw its profits fall by 92%.  The fertilizer and agriculture stocks have looked ill for a while, and this news reveals why.
  • In the category of biff! pow! sock!–or the Law of Unintended Consequences–Wells Fargo said it would “raise credit card rates ahead of U.S. law imposing limits,” while Bank of America said it would, “maintain credit-card rates ahead of” the law.
  • Given relative price movements, ExxonMobil edged out PetroChina to become the world’s largest company by market capitalization.
  • In a sign that maybe it’s much ado about nothing (i.e. tightening monetary policy) Australia announced an increase in its monetary policy rate (ala Fed Funds) in response to a stronger economy.  That pushed its stocks and currency higher.
  • You knew this would happen.  Dear Barney Frank is proposing that the TARP funds repaid by banks be used to buy votes help with foreclosure aid for the jobless.  No, it wouldn’t aid in the foreclosure process, merely kick the ball down the street instead it would help them stay out of it.  That would be contrary to the experience of past mitigation efforts where it really does just push the problem further out.

This Week

Cut to the chase:  relatively few economic releases this week, and none were of the variety that typically set markets on their metaphorical heels.  It’s more of the same, the economy’s Waiting for Godot.*

*  While this sounds sophisticated and French, I’ve never seen this [shamelessly lifted from Wikipedia]  “play by Samuel Beckett, in which two characters, Vladimir and Estragon, wait for someone named Godot.”

I’ve seem it referenced before by other investment types, and while I really probably should read or see it, the fact I haven’t won’t stop me from acting like I have.  Wikipedia goes on to say that, “Waiting for Godot follows two days in the lives of a pair of men who divert themselves while they wait expectantly and unsuccessfully for someone named Godot to arrive. They claim him as an acquaintance but in fact hardly know him, admitting that they would not recognise him were they to see him.”  Sounds vaguely like a rebound in the economy or a raise.

On Monday, the ISM Non-Manufacturing survey was empreleased.  The erstwhile folks at the Institute for Supply Management must have created the survey before the economy assumed its current status as a service economy.  Up ’til now, the ISM Manufacturing report has been the report–of the two–more likely to move markets, and yet, as the pie chart to the right illustrates, markets should be paying far more attention to this week’s report, with service employment comprising 73% of nonfarm payrolls.  But I digress; the survey improved to 50.9 from 48.4, and that was a bit better than expected by economists (50.0).  This was the survey’s first foray into expansion (i.e. >50%) territory since midway through the time since the recession was deemed begun.  The trouble with the survey is that  it’s a survey of sentiment, not of hard data, and respondents’ views are colored by things like their own 401(k) balances, which are up, as is the general zeitgeist.  Consumer Credit outstanding contracted again, but at a slower pace than in July.  Economists thought it would contract by $10 billion; it fell by $12 billion.  July’s monster decline of (-)$21.6 billion was revised lower (closer to zero) to (-)$19.0 billion.  Of the decline, $9.9 billion was revolving (i.e. credit cards); the balance, everything else.  An impressive-sounding decline in the American consumer’s profligacy until one considers it against a backdrop of total consumer credit of $2.46 trillion.  Mortgage Applications jumped by 16.4% to show that, drops in outstanding credit notwithstanding, the American consumer knows a bargain when he/she sees one.  National mortgage rates over the last week fell from 5.13% to 4.93%.

There’s a lot of talk about this being a jobless recovery–and I even saw “consumer-less” this morning–and that may be the case, but at least the rate of job loss continues to go in the right jcdirection as evidenced by the chart at right showing Initial Jobless Claims over the last two years.  First-time claims for unemployment benefits for the week ended October 3 totaled 521,000.  Economists expected a figure of 540,000, both of which figures would have marked an improvement over the prior week’s figure (554,000, revised up from 551,000).  Being from the midwest and lacking advanced degrees from really prestigious schools in the northeast–barely having secured degrees from marginal institutions–we keep things simple around here, and here’s simple in action.  Both the four-week moving average of claims, and claims themselves, made lower lows this week.  That suggests to us that job losses will continue to decline.  Charges of, “you don’t really believe all that chart @$^%, do you?” deserve the retort, “yes, since it’s a lot easier than trying to figure out what’s really going on.”  We’ll leave that to all those prestigious-institution-diploma-bearing solons whose record of wins and losses versus the indicators are less than stellar.  Here’s the whether (yeah, yeah) forecast for jobless claims, cloudy with a chance of sunshine (i.e. heading lower over the next weeks.)

Finally, Wholesale Inventories continued to decline.  That is, from July to August (yesterday’s data), inventories contracted again, by (-)1.3%.  The decline from June to July had been -1.4%; it was revised to -1.6%.  So, the rate of change improved–although the revision suggested the inventory picture continued to deteriorate–and that will help out GDP, as described here.  But there is still no inventory rebuilding going on.

Next Week

 In contrast to this week, next week is chock full of releases.

WednesdayBusiness Inventories  for the month of August are reported.  They’re expected to have, what else, fallen by (-)0.8%.  If so, that will mark an improvement over July’s drop (-1.0%.)  The Minutes from the September 23 FOMC meeting will be carefully reviewed, especially in light of the Fed’s ill-advised prepping of the market for rate increases.  No, the prepping’s not bad, but the rate hikes could be.  Expect those minutes to repeat this common theme amongst the Fed gurus, this version from Chairman Bernanke last evening: 

“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”

To be fair, while the idea of removing stimulus measures too soon has been one of the causes of–hold your nose–W shaped recoveries (rebound followed by a second dip)–at a zero percent policy rate, the Fed could raise rates several times (assuming 0.25% at a clip) before running into neutral, let alone restrictive policy rates.  In 1993, a very smart looking economist, John B. Taylor, came up with the eponymous Taylor Rule to provide an objective target rate for the Federal Reserve.  ‘Looks like this:

taylor

In short, the target rate (i-sub t) is devised by looking at three things:  the real rate of interest, growth in the economy, and slack in the economy.  The estimable folks at BCA Research have done the calculations and have found that the Taylor Rule says zero percent is just right.  More than anything else, the Taylor Rule is found to have closely approximated past rate decisions of the Greenspan-led Fed.  BCA estimates that rate hikes won’t be needed until late 2010.  There is massive slack in the economy (more on that, below), and talk of inflation is equally premature.

Thursday – the Consumer Price Index will likely confirm that view when September consumer price data is released.  Economists expect that, on a year-over-year basis, the headline inflation rate on consumer goods was -1.4% and, coincidentally, net of food and energy prices, was (+)1.4% for the same period.  Regarding the weekly release of Initial Jobless Claims, the elusive consensus economist looks for a small bounce in first-time claims to 524,000 (from this week’s 521,000.)  That’s a bit laughable in that last week at this time they were looking for 540,000.  Our fearless broken-clock forecasting model calls for 494,000.  The index hasn’t been below 500,000 since the first business day of the year.  In the category of please-disperse-there’s-nothing-to-see-please-go-about-your-business, we wrap up Thursday with a look at two regional Federal Reserve surveys, Empire State Manufacturing and Philly Fed.  The former is at levels last seen in the eons-ago data of November 2007; the latter, back to June 2007.

Friday – the twin release of Industrial Production and Capacity Utilization is scheduled for 9:15.  Some have said that one would be hard pressed to find two better pieces of data to describe an ip1economy.  The nation’s output is captured in industrial production, and the usage of its productive capacity is captured in the latter.  Here’s a look at Industrial Production, and it doesn’t look so good.  The blue line is the level of production, and the arrow highlights that it has fallen to February 1999 levels.  The red line tracks the ten-year change in industrial production.  Not since just before the production ramp-up associated with World War II have seen such a decline (red dashed line).  The expected uptick of 0.1% in September that economists anticipate will do little to change the trend.  Naturally, we should have ample capacity–or slack, as the Taylor Model uses–in the economy as a result.  Indeed, the numbers for Capacity Utilization should bear that out, and they show the economy using just 69.6% (increase to 69.7%, expected) of available capacity.  We finish up the week with University of Michigan Consumer ConfidenceumconfIt’s recovered to such a degree that we’re pushing the bottom edge of the range we were in for the last several years, but we remain well below average levels.  Arguably, the source of the consumer’s confidence is not the improved prospects for his neighbor keeping his job, and it’s probably not the consumer’s own prospects for a raise.  The source of his subdued enthusiasm is rising stock prices, and we know all to well how ephemeral those are.

Wishing you a happy Columbus Day, I remain your humble scribe,

Graig Stettner, CFA, CMT – Vice President & Portfolio Manager – Tower Private Advisors

Please direct all complaints about this e-mail to Mike Cahill, CEO of Tower Bank & Trust, who undoubtedly cringes when he reads–assuming his does–this dispatch.  That should remind you that this e-mail does not reflect the views of my employer, my colleagues, none of my three friends, nor my five beautiful children and their far-more-beautiful mother.

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