Shedding some light on the violent stock market moves

Have you ever heard of the saying Be careful what you wished for? It turns out that traders wished to see some growth in average hourly wages, some inflation over deflation and yields on long duration bonds to go up. They got their wish which started a violent market correction.

Market watchers remain at odds over what tripped the sell switch. Primarily, the conversation comes down to fundamental vs. technical. In the days since the correction began the markets have recouped more than half the downside since the low point.

Plenty of theories, I call mine “The Domino Effect”

Inflation fears was the first domino to fall hitting the fear of raising interest rates. The next domino to fall was money managers and institutional investors were caught with a lot of leveraged positions. The sharp fall triggered margin calls causing massive sell orders. This initiated sell orders from funds that use technical analysis better known as quantitative funds. The last domino to fall was retail investors (who haven’t seen a correction in over two years) did some panic selling.

The Dow suffered two drops of 1,000 points. The fall seems big but the actual percentage was not extraordinary. There have been larger percentage drops in the past. In my 35 years of investing, I have experienced some worse percentage downward moves.

Rank Date Close Net change % change
1 October 19,1987 1,738.74 −508.00 −22.61
8 October 26, 1987 1,793.93 −156.83 −8.04
9 October 15, 2008 8,577.91 −733.08 −7.87

 

Is the correction over?

The market fundamentals haven’t really changed. U.S. corporate earnings are getting better and the Trump tax cuts should boost economic growth. Plus there is systematic economic growth happening in both developed and emerging markets.

I am not an expert on technical analysis and I don’t believe in buying or selling based on lines on chart. However, pension funds, hedge funds and quantitative funds use technical indicators to manage a large amount of investors’ money. 

Analysis from Kensho, a quantitative analytics tool used by hedge funds, looked at seven occasions of similarly sharp drops in the S&P 500 beginning in 1987. The study found that following such a drop, stocks tended to fall further, with a median decline of 2.29 percent one week later and a drop of 1.68 percent two weeks later.

 

This is the ABCD bullish chart:

This is the year to date chart of the S&P 500:

In my humble opinion, corrections tend to last more than nine days. I put some money to work last week and plan on dollar cost averaging on some more positions. If you are new to my blog, consider reading:  Dollar-cost averaging using an option strategy

What do you think? Are you buying the dips or selling into the rallies?

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Home bias adds sector risks for investors

 

 

 

 

 

 

 

Legendary investor Warren Buffett, among others, is notorious for telling investors to buy what they know. Basically, Buffett and his enthusiastic followers suggest investing in companies that you really understand or at least know enough about them to be able to explain how they make money.

That is fairly good advice if you are an American since the S&P 500 generates nearly half of its revenue from outside of the United States. However, there is still a lot of risk in the form of sector concentration. For example, the tech sector accounts for nearly 21% within the S&P 500.  Do you remember the bursting of the dot com bubble?

Home bias for Canadian investors is really risky. Seventy–five percent of the Toronto stock market is dominated by three sectors, energy, materials and financials. There are only a handful of companies in other sectors that are available to further diversify your portfolio. Year to date, the Toronto stock exchange is only up 5% compared to the S&P 500 which is up 18.5%, see chart below:

The Canadian market has under-performed when compared to the U.S. markets for the past five years. The main reason is the decline in oil prices which has effected many non-energy sector companies which still rely energy prices in determining their revenue growth. For instance, Canadian banks may rely on loans to energy companies to drive their growth rates. See the 5 year performance chart below:

Why home bias exists

Vanguard’s Investment Strategy Group identified a range of reasons why investors might not embrace global diversification, including concerns about currency risk and an expectation that their home country will deliver out sized returns.

One factor we identified—preference for the familiar—seems particularly relevant. With so much global uncertainty about geopolitics, monetary policy, and the economic outlook, it’s understandable why investors may not want to stray too far from home.

Why Canadian markets may continue to under perform the U.S.

  • Oil and gas exports are land locked and selling at a huge discount!
  • The housing market is slowing down due to a 15% foreign buyers tax, tightening mortgage rules and higher mortgage rates.
  • Tariffs on softwood lumber and airplanes from our largest trading partner (U.S.) has put the success of re-negotiating NAFTA questionable.
  • Passing of the U.S. tax reform legislation will make investing in Canada less attractive (plus we have a carbon tax and high electricity rates).
  • Canadian consumers are carrying high levels of debt which will slow down spending.

Exchange traded funds are a low cost way to diversify your portfolio outside of North America. Many providers offer the ability to hedge fluctuations in foreign currencies. 

The markets are due for a correction, I would recommend slowly increasing your exposure to the U.S. stock market.

A fun exercise: Stock picking verses indexing

The average person is afraid of investing in individual stocks and 61 percent of millennials say they’re afraid of even getting started. Despite the fact that investing in the stock market has been shown to be the most efficient and effective way of turning money into more money.

Financial website How Much took a look at some popular stocks in 2007 to find out how much a $1,000 investment in each would be worth now, as of October 31.

In the above picture, the blue dots are equivalent to the $1,000 initial investment, so they are the same size for each company. The pink ones represent the current total value of the investment, so each of those varies.

The larger the pink circle, the more your investment is worth,” according to How Much. “If the pink fits inside the blue, then you lost money. The graphic assumes that you took any dividend paid out in cash and did not reinvest into the company by buying more stock.”

Warren Buffett, Mark Cuban and Tony Robbins all agree index funds are a safe bet, especially for new investors, since they fluctuate with the market, stay pretty constant and eliminate the risk of picking individual stocks. However, if you were lucky enough to pick these 15 American stocks, your $15,000 would have been worth $99,291 compared to $26,741 for the S&P 500 (SPY).

What if you missed owning the two top performing stocks Netflix & Amazon? Your total return would have been $34,927 assuming that you didn’t panic during the great recession. There are other household names like Facebook or Visa that could have help you beat index returns.

Keep in mind, it is easy looking backwards! I do remember getting phone calls and emails from formal clients and co-workers looking for advice during the market meltdown of 2008-09. It is hard to do nothing and hold on to your investments when markets are down 35% to 45%!

My point is simple, even with the worse meltdown (2008-09) since the great depression of the 1930’s, you would have still made money investing during the past ten years. Investing in the stock market is still the most efficient and effective way of turning money into more money.

 

 

 

Upcoming blockbusters could boost movie chain stocks

I have to admit that one of my guilty pleasures is watching movies on a big movie screen. My wife and I really enjoy science fiction and superhero type movies. We see anywhere from 10 to 15 movies every year. Sometimes we will even see the same movie more than once.

2017 has been a rough year for the film industry, with the North American box office suffering its lowest-grossing summer in 25 years. Ticket sales are down 10.8 percent this summer and have decreased by nearly 3 percent year to date. Box office flops such as “The Mummy” and “Baywatch” have hurt Hollywood but there will be some upcoming movies this year that could turn into blockbusters.

Release dates in November and December of 2017 include Thor: Ragnarok, Justice League and my personal favorite Star Wars: The Last Jedi.  Upcoming movies in 2018 appears to be very strong with:

  • Black Panther
  • X-Men: The New Mutants
  • Avengers: Infinity War
  • Han Solo,
  • Deadpool 2 
  • Ant-man & The Wasp.

However, investors have really punished the movie chain stocks. U.S. chains, Regal Entertainment (RGC) and Cinemark (CNK) are down 35% & 25% respectfully over the past 6 months. Cineplex (CGX) the largest Canadian chain is also down 25%, see chart below:

The vast majority of theaters in the U.S. keep a larger percentage of the ticket sales the longer the film is in the theater. For example: opening weekend they may get 10%, the 4th  week up to 25% and the 10th  week up to 50% or more. While concessions account for only about 20% of gross revenues, they represent about 40% of theaters’ profits. Profit margins on soda and popcorn average 85 percent.

All three of these stocks pay dividends, Regal has the highest yield of 5.7% followed by Cineplex at 4.35% and Cinemark with 3.43%. I expect that their 3rd quarter results could disappoint which would be a good buying opportunity. However, there is a risk that the price of these stocks could move up in anticipation of better future earnings.

Possible ways to trade a rebound in movie chain stocks

  1. Take a half position now and buy the other half after 3rd quarter earnings are released
  2. Buy a full position near the ex-dividend date, to get paid while you wait
  3. Buy half position, sell covered calls and sell cash secured puts for the other half.
  4. Buy some long calls near 4th quarter earnings release scheduled for Feb. 2018

Being an option trader, I am going to wait until Feb 2018 options are available. If the VIX which measures volatility stays low, I will probably buy a call option on one or two of these stocks.

 

Disclaimer: This post is for discussion purposes, do your own research.

Why you should look under the ETF’s hood

A fund’s name might seem like a good starting point for gaining an initial understanding of how it is constructed. Unfortunately, names turn out to offer little help for evaluating funds. There is simply no universally accepted system in use by ETF providers and research to classify funds. For example “Infrastructure” would seem to have something to do with the amenities, roads and power supplies needed to operate society.

Names can be deceiving! To illustrate, I went to one of my favorite ETF provider’s web site to look under the hood. I was looking to find some discrepancies. It took some time but the geographic allocation in the fact sheet on the BMO Global Infrastructure Index ETF (ZGI) wasn’t global at all but had the majority of their holdings in North America.

  • 66.02% United States
  • 25.16% Canada
  • 6.71% United Kingdom
  • 1.56% Mexico
  • 0.56% Brazil

The top ten holdings also have a lot of pipeline companies who pay construction companies to build the actual  infrastructure.

  • Enbridge 10.07%
  • American Tower Corp 8.82%
  • National Grid Plc 6.71%
  • TransCanada Corp 6.68%
  • Crown Castle Intl Corp 6.07%
  • Kinder Morgan 5.87%
  • P G & E Corp 5.17%
  • Sempra Energy 4.25%
  • Williams Cos 96%
  • Edison International 3.82%

It takes years for pipeline companies to benefit from any new capacity to come on line. On the other hand, companies who specialize in construction & engineering like SNC-Lavalin or Aecon would see immediate revenue growth. I would recommend looking for another infrastructure ETF that had more global exposure with holdings of construction & engineering type companies.

Another example is the BMO S&P/TSX Equal Weight Industrials Index ETF (ZIN) which has a small discrepancy. The fact sheet says it has 26 industrial holdings but two of those holdings include airlines. (Air Canada 5.46% & Westjet 4.13%)  Now both of these companies buy industrial products but they specialize in transportation.

Here are some key steps all investors should take when evaluating ETFs:

  1. First, decide if you are going to be a do-it-yourself investor or work with an advisor. As their name suggests, ETFs are traded on exchanges, so they can be bought and sold like stocks through a discount brokerage.
  2. Make sure you understand the index underlying the ETF you are considering. Focus on how the index is constructed, what it tracks and how long it has been around. A longer record will reveal how the index responded to different market conditions.
  3. Check the fund’s fact sheet, are the underlying holdings and geographic allocation accurate? How does the exchanged traded fund compare with similar funds from other providers?
  4. Avoid ultra-short and leveraged ETFs, leave those to professional traders.

Ultimately, the proper implementation of ETFs in a portfolio requires, like all investment decisions, due diligence, caution and persistence. ETFs can offer many attractive features but their long-term value depends on how well they fit into an individual’s portfolio.

To evaluate an appropriate fit, investors have to be prepared to look under the hood.

 

 

 

Share buyback binge is going strong, investors beware!

Is there anything wrong with this? Yes, it means that companies are spending more money on “financial engineering” than on capital spending. It certainly does indicate that companies are at a loss on how to improve their top line, which is what will ultimately improve the bottom line. It leads to frequent complaints by analysts about the “quality” of earnings.

It’s a very important point. Apple is part of an elite group I call “buyback monsters,” companies that have been aggressively buying back stock for years. Apple’s shares outstanding topped out in 2013 at roughly 6.6 billion shares. Since then it has been down every year and now stands at 5.2 billion.

That is a reduction of 21 percent in shares outstanding since 2013. What’s that mean? It means all other things being equal, the company’s earnings per share are 21 percent higher than they would have been had it not done the buybacks.

But that’s only since 2013 … there are companies that have been doing this much longer. IBM shares outstanding topped out at 2.3 billion way back in 1995, it’s been going down almost every year since then, and now stands at 939 million shares. Think about that. That’s a 60 percent reduction in shares outstanding in a little more than 20 years.

Same with Exxon Mobil, after the Mobil acquisition in 1999, shares outstanding topped out at just shy of 7 billion in 2000 and have been going almost steadily downhill since. There’s now 4.2 billion shares outstanding, a reduction of 40 percent since 2000.

Here are just a few more buyback monsters:

  • Northrup Grumman: 50 percent since 2003
  • Gap: 55 percent since 2005
  • Bed Bath & Beyond: 50 percent since 2005
  • McDonald’s: 36 percent since 2000
  • Microsoft: 30 percent since 2004
  • Intel: 30 percent since 2001
  • Cisco: 32 percent since 2001

Why are there buybacks at all? They were originally used to support the issuance of stock options. The options increased the share count outstanding, so to keep the countdown the company bought back shares. But as the opportunity for significant top-line growth waned, buybacks to reduce share counts became a separate strategy to prop up earnings growth.

What is my beef with buybacks? Part of management’s compensation packages include stock options. Buying back company shares ensures that their stock options don’t expire worthless.  It not only fools investors that the earnings are growing but it rewards poor management.

Take IBM for example, despite being one of the most aggressive buyback monsters on the Street, you can’t say IBM’s stock price has soared in the last decade. In 2014, the company eased off a bit on its buybacks, and the stock headed south. It headed south because IBM was beset by fundamental growth issues: Its revenues from its old line businesses were shrinking and there was not revenue from emerging  businesses (like Watson and artificial intelligence) replacing it.

The lesson: No amount of financial engineering like buying back shares can replace management’s inability to grow the business.

 

 

Opportunities for option traders on the takeover of Time Warner

Back in late October, I wrote that AT & T had reached an agreement in principle to buy Time Warner for about $85.4 billion, Time Warner shareholders would get a combination of cash and AT & T stock. The total purchase price would be around $107.50 and the whole process could take around a year to complete.

Click here to read “Looking for option trades on the Time Warner takeover by AT&T”

The stock price of Time Warner was trading at around $86.75 at that time which was way below the takeover price. I suggested two option trades with April expiry dates and one that didn’t expiry until Jan 2018. All three trades turned out profitable.

  1. Buy 300 shares of Time Warner at $86.75 and sell 3 April $90 call options for $3.00 each. This reduces the adjusted cost base to $83.75 and I am hoping that these call options will expire worthless.

Results: Time Warner stock was called away at $90.00 in April for a $6.25 profit or 7.46% in 6 months.

  1. Buy 100 shares of Time Warner at $86.75, sell 1 April $90.00 call option for $3.00 and 1 April $85.00 put option for $3.80 reducing the purchase price to $79.95 a share. ($86.73-$3.00-$3.80 = $79.95)

Results: Time Warner stock was called away at $90.00 in April and the put option expired worthless. Profit of $90.00 – $79.95 = $10.05 or 12.5%

  1. Buy 10 Jan $97.50 call options for $3.50 that expire in 2018. If the deal goes through, these options could be sold for $10 each.

Results: Time Warner stock closed at $99.18 on Friday, I still have 8 more months to take profits. I could sell the Jan $97.50 call options for $6.05 on Monday for a profit of $6.05 – $3.50 =$2.55 or 73%

Being a senior, I totally forgot about this post, I have to apologize for not providing an update sooner. However, I repeated option strategy number 2 by buying 500 shares of Time Warner at $97.50, selling 5 May 97.50 call options for $1.95 and 5 May 97.50 puts for $1.45 (which reduced my purchased price to $94.10) and made $3.40 or 3.6% in one month.

Unfortunately, the VIX which is the ticker symbol for the Chicago Board Option Exchange volatility index has been falling. It measures the market’s expectations of 30 day implied volatility. (Referred to as the fear index) A falling VIX means a reduced amount of fear and cheap option premiums.

Despise the lower possibility of profit, I repeated option strategy number 2 and bought 500 shares of Time Warner at $98.96, sold 5 June 30 100 call options for $1.00 and 5 June 98 put options for $1.00 reducing my overall cost to $96.96 per share. I could potentially make $3.04 if TWX is above $100 by June 30th or 3.14.%

A falling VIX tends to widen the bid / ask price spread on most options. It makes it harder to get your order filled. I had to change my limit order a couple of times during the day to get this Time Warner trade completed.

There is always a risk that this deal will not be approved by regulators. However the takeover price gap has narrow from $86.75 / $107.50 in October to $99.18 / 107.50 in June. A good sign that investors believe that this deal will go through.

Disclaimer: This post is for educational purposes only.