Why the market is down now for 2 days.

The US stock market indices are down this week for one simple reason: POLITICS. Nothing else has changed.

NYT: G.O.P. Extracts Price for Averting Shutdown

WaPo: We’re two days away from a government shutdown. Here’s what’s at stake.

IBT: Government Shutdown 2014: What Will Happen If The Federal Government Doesn't Pass A Budget

The Case for Aflac

Unlike the stock featured on my previous post, my old screen gave me a decent company with Aflac.It hasn't soared, but my current option strategy does not require a fly highing stock, just one that is stable to be profitable. And this is what AFL has given me. It is a stock with a long history of rising dividends and currently with a low PE ratio of 9.4 with an expected 5 yr Earnings growth of 6%pa.

So why is the duck not soaring?

1. Japan. 74% of AFL business is in Japan and the country is now "officially" in recession with the last two quarters' GDP print being negative. 
2. Abenomics has only helped to lower the value of the USD:JPY exchange rate. This has caused lower repatriated profits for the US company.
3. Although the company is a steady operator, it's next year expected earnings growth rate is almost zero. More growth is expected in the out years, though.

But let us get back to the good things that will sustain AFL's strong balance sheet, steady cash flow and stable price base.

1. In Japan, it has a very solid agreement with Japan Post. In case you are not aware, the japanese use the post office as a bank, making it one of the world's largest financial institutions. This makes it a perfect venue for selling all kinds of insurance. The agreement should help the revive growth of japanese sales for the company.
2. On top of the long history of increasing dividends, making it part of the S&P Dividend Aristocrats list, it has also been implementing Share Repurchase Program that should give some price support to the stock price by increasing the EPS.
3. As a company, it has one of the most respected and admired companies in the world.This reputation makes it an easy sell to clients, representatives and all other stakeholders.
4. Sales in the United States are slowly growing, but should improve along with the employment picture given that much of the insurance are sold through employers.

Keep on Quacking.

The Case for Transocean

Thanks to a poorly constructed stock screen, I ended up entering a bullish option spread on Transocean, Ltd (RIG). This has been quite a bad trade, but since it is inside a test portfolio, I have not divested of it to experiment on how to salvage a bad situation.

The purpose of this post is to spell out the reasons I think RIG is a good company in the middle of a cyclical bloodbath. Without going into detail of my ideas on it, here are the main reasons I think this stock will recuperate quite well once oil prices stabilize.

1. The large dividend is safe because of the financial flexibility provided to it by the MLP RIGP.
2. Transocean opened a $3B 5 year revolving credit facility on June 2014. (See 10-Q for details)
3. Also according to the 10-Q, Scheduled Maturities over the next quarters ending in 3Q16 equal $1.4B. This figure does not include the $207M redemption in November of the outstanding 4.95% Senior Notes due 2015.
4. The balance sheet is healthy as attested by Fitch in November: "Fitch views the timing of this month's impairment as a signal to the oversupplied market that, consistent with our view, industry-wide rationalization is needed ahead of scheduled newbuild deliveries to improve market balance and, ultimately, realize a cyclical improvement. Transocean has illustrated that rationalization can strengthen its cash flow and asset profile. This is evidenced by the stabilization of EBITDA and improvements in utilization and day rates following its 2011 impairment."
5. Fitch rates Transocean as Stable BBB-, the lowest of Investment grades. But the implied rating based on the CDS price is a much better BB-.
6. The $24B backlog of contracts should allow RIG to keep the fleet at work through the downturn even if it lasts into 2016. Note that in the November Fleet Summary, the expected Out of Service days actually went down by 225 for 2015.

Based on the financials, RIG should be well positioned to go up once the oil market stabilizes from its swan dive and the oil producers are able to reengage in Capital Expenditure planning.

Asset Bubble and How It May Pop...in 2016.

No. I'am not a Bear yet. Like I've said before, I see an 85% chance that the Bull market will continue into 2016. But I do think a fair amount of effort should be put in watching for the current easy money driven bubble in Bonds to burst.

US Stocks are richly valued, but not to the point of previous market frenzies. I'll be more bearish when the Trailing PE multiple of the S&P 500 is scratching 21. (e.i. the index would have to be above 2200 today).

To get there, we need more money to go into Stocks. That will have to come from the Bond Market. As interest rates rise, eventually, a Bond selloff will begin and move to stocks as the US Economy will be seen as strong to support higher stock multiples because of expected accelerating earning growth, as seen with the November Jobs numbers out today.

The Bond market has been seeing a flight to quality rotation for some time as you can see in this graph depicting the ratio of the TLT and JNK ETFs as the Proxy for the 20 yr Treasuries and the High Yield market.

The High Yield market is under threat from the marginal Oil Shale producers that are in danger of default if oil market doesn't at least stabilize soon. 

As the bond market deflates, all that money will go into the Stock market and multiples will begin to get high overall. At which time, the prudent investor should be looking for the door as the final leg up of this long bull market cycles back into a retreat. 

For now, the trend looks positive for now.

Electricity Utilities Should Do Well For A Little Longer.

Utilities tend to be the boring but stable part of most investors' portfolios. With their steady income streams and reliable dividends, they tend to act as a bond with a growing coupon would. They also tend to have low Betas, i.e. low reactivity to broader market swings.

Current market conditions favor electric utility stocks on several fronts:

1. Low energy input prices, such as gas, oil and coal are expected for the foreseeable future.
2. As bond equivalents, they should lose favor as interest go up. Few investors are expecting any large moves from the Fed and other Central Banks have only just begun to flood the markets with liquidity, thus keeping interest rates on the low side.
3. As US GDP is expected to keep growing throughout 2015, electricity usage should be stable.

If oil and coal prices go up, or interest rates begin going up, this could likely bring utility stocks down as prices go up and bond yields become more attractive.

Two stocks I find attractive are Consolidated Edison (ED) and PG&E Corporation (PCG). They are both well ranked within the industry, have favorable earnings momentum and comfortably below their Price Targets.

I am currently using a Positive Delta, Positive Theta option spread strategy on both these low Beta plays. I can profit as long as price stays near or above the strike prices I use on each.

Market Indicators I Like: 1) VIX Futures Premium

From time to time, I'll be listing market technical indicators I use to gauge the strength of the US Stock Market.

From the front page of iVolatility.com, I like to look at the VIX Futures Premium. It measures how much more are hedgers willing to pay for Implied Volatility  (i.e. the risk premium for options on the S&P 500 Index) in the future two months than in the current spot market. If hedgers are worried of an upcoming downturn, they are likely to pay more for the current spot market protection than for future, bringing the Premium down to negative levels. If, on the other hand, hedgers are less worried about the risk of a market downturn, then they will be less eager to buy protection now, then in the future, making the Premium higher.

iVolatility instructs its users that a VIX Futures Premium:

Premiums for a normal term structure are 10% to 20%, while premiums above 15% appear to suggest a lack of enthusiasm for VIX hedging. Premiums less than 10% suggest caution and negative premiums are unsustainable suggesting an oversold condition. 

 Today at market open the premium is at +15.37% suggesting a continuation of the uptrend.

I recommend that every Monday morning you read, like I do, their weekly newsletter.

2015: A Raging Bull Market or a Financial Apocalypse?

All over the internet and on the financial media, pundits, gurus and experts are making their prognostications for the market direction in the coming year. There are basically two extreme voices out there. First, the Pro-Keynesians who believe the Fed and other central banks are creating a Goldilocks scenario of growth in a low inflation environment. And second, those with a more Austrian Business Cycle approach who see QE-infinity as just a doomed attempt at re-inflating the bubble that will lead to a collapse of all fiat currencies..

Personally, I am of the Austrian view, although I’m not in the Doom and Gloom camp in the short to medium time-frames. I accept that all the money creation is ultimately a form of currency debasement done out more of dogmatic ignorance than of outright malice. And this debasement, that can be traced back to the 1913 creation of the Federal Reserve, could in the long run make the world economy go into shock and seizure.

I also realize I am in the minority. The majority tend to be more sanguine and thus will likely drive stock prices higher and make this market cycle not that much different than any others. The “This Time is Different” Fallacy applies to both Bears and Bulls.

Given this, I am 85% sure that the U.S. stock market will continue to rise and multiple expansion will continue as part of the more or less normal market cycle script in 2015. Before a true stock market bubble happens, the bond market bubble must burst first and push that money flow into the stock market and Trailing PE multiples should be in the low to mid 20s (For more on the end game, I recommend this podcast with Jim Puplava of Financial Sense.). 

If we take the current 2015 earnings estimate for the S&P 500 of $134.89 and we shave off 10%, just to be conservative, we end 2015 with $121.40 earnings. Now we apply a 20x PE multiple we get an S&P 500 index over 2400.

So what about that 15% doubt?  Well, I’ll tell you how I’m preparing for that in my next post.

Calendar Strangles.

In my previous post, I wrote about how to make directional trades using options without worrying about time decay with Directional Calendar Spreads.

In this post, I will introduce you to the Calendar Strangle, a non directional play on volatility without worrying about time decay. This can also be called a Double Calendar Spread as it is made up of two Directional Calendar Spreads: one bullish using out of the money calls and one bearish using out of the money puts.

To set one up, first you have to look for an underlying with with an implied volatility that is low relative to it's yearly range. Implied volatility tends to be mean reverting, so if the volatility is low, there is a good chance that it will raise back to it's mean and beyond to the other extreme eventually. Usually between earnings announcements, a stock's implied volatility will be at it's lowest only to raise as the date of the announcement draws near.

Once you have your candidate, you will want to sell the nearby month's options. I would recommend you sell the calls with a delta of around 0.18 and the put with the -0.18 delta. And buy the call and put for a few months forward at the same strike prices as the corresponding option rights. This spread will be delta neutral when initiated, while having a positive vega and theta.

There are four things to watch out for in this spread. First, the bid-ask spread of each option in the strategy accumulates, so the bid ask spread becomes very wide. The best way to deal with this is to screen for underlying's with deep option markets and always use limit orders on the entire combination of options to try to get a price as close to the midpoint as possible.

Second, as the earnings announcement day draws ever nearer, the term structure of the implied volatility may work against you as the front month's implied volatility rises much faster than the later months. Ideally the front month of the spread should expire the day before the announcement. This is because at announcement, the underlying may move a lot and you may need to exit the spread having to buy back the front month at an inflated risk premium.

This brings us to the third issue. When the underlying price hits either of the strike prices, it is the time to exit. Ideally, this would happen as the front month expires for maximum profit. Price alerts must be placed to be ready to exit.

And the fourth and final issue is about the time between the expiration months. If you space the options with a small time difference, your required capital will be less and your return on it will be higher, if the trade is successful. The downside of this is that you'll have less time wait to achieve success. A longer time difference will give longer time to make turn a smaller profit. If the front month expires while the underlying is still between the strike prices, the spread can be reengaged by selling the new front month's options at the same strike prices.

My preference when using this strategy is to favor large ETFs with deep option markets. There will be less opportunities to find the right time in the implied volatility cycle, but in my experience the term structures are more stable then with earnings announcing equities.

Directional Calendar Spreads.

One big issue of speculating with options is time decay. You may have a solid bullish or bearish thesis on a stock and think that buying a call or a put will be a good trade, but if the market doesn't move in your favor soon and far enough, the value of you option will fall quickly with time.

I find that the best way to do a this type of speculation is a calendar spread (sell one front month option, buy a back month option) that shifts away from the current underlying price. The strike price of the calendar spread should be shifted towards the expected price move: higher for bulls and lower for bears. I like setting it up so that the Delta of the front month option to be sold is about .20 for a bullish call calendar spread, or a -.20 for a bearish put calendar spread. I prefer to use out-of-the money options for this spread, but it can be done with in-the-money options as well since the intrinsic values cancel each other.

The amount of time between the contracts also matters: the bigger the time spread the better the time decay advantage because of a higher positive theta. It also allows for more time for the market to move your way. If the market doesn't move your way by the time the front month option expires, you just sell the new front option at the same strike price.

One thing to watch out on this trade, besides a wrong directional thesis, is a fall of implied volatility. Although the spread has a reduced Vega, it is not neutral, and any change in the slope of the implied volatility term structure can affect the value of the spread before the front expiration.

Another issue is that the spread is at its maximum value at the strike price. You must unload the spread then and take your profits. Ideally it should hit the strike price at expiration, but if it gets there before that, play it safe and close it out.

Also watch out for wide bid-ask spreads. As with any spread, you are trading two or more securities as one, and each individual bid ask spread add up to a big one. It is best to look for underlying stocks with deep option markets to avoid this problem, or else you'll need patience to bid for the spread somewhere near the midpoint of the bid-ask spread.

Next week I'll write about a variation on this spread.