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The Time To Hedge Is Now! 2 New Candidates To Add Before It’s Too Late

Summary The introduction contains a brief overview of the series. A couple of things to consider for those still on the fence and unhedged. A list of candidates including two new ones to consider. A discussion of the risk inherent to this hedging strategy relative to not being hedged. Back to Or Is IT Too Late? It is not too late to hedge, but doing it cheaply is getting harder. Most of my positions are working, but not all have shifted into gear yet. Some are not sporting gains as high as 1,200 percent. But this, as series followers know, could be just the beginning. If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog. It may be more difficult to follow the logic without reading Parts I, II and IV. In Part I of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process, and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options, and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December 2014 update explains how I have rolled my positions. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term, you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but had also have eliminated the big losses. It makes a really big difference in the end. A note specifically to those who still think that I am trying to “time the market”, or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five-year period, I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more, I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point, the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. A couple of things to consider for those still on the fence and unhedged In my last update I mentioned the two things I am going to be watching on Monday morning are what happened in China equities and whether or not the price for WTI crude oil has held above $40 over the weekend. As I write this late Sunday evening, the Shanghai Index is down by over seven percent. That is not a good sign! I just checked the price of WTI crude oil and it currently stands at $39.37/bbl. This is also not a good sign. I may be wrong, but I suspect that U.S. equity markets will open lower on Monday once again. Chris Ciovacco does a weekly video that focuses mainly on technical analysis of U.S. equity markets. This last week was particularly interesting. He is very balanced in his approach, neither a bull nor a bear. He has a good set of rules that he strictly follows. It is well worth a few minutes to watch. Another eye opener is this article about falling container rates from Zero Hedge. This site tends to be mostly bearish but they do make some good points. I think this one is worth considering. A list of candidates including two new ones I will start with the two new candidates that I want to add for your consideration. I plan to try to add a small position in each as described below near the opening on Monday. First up is Masco (NYSE: MAS ), a manufacturer of home improvement and building supplies. I realize that the housing market has been humming lately and that is why this company has so far escaped the ravages of the last few days. As of Friday’s close, Masco was down only 7.2 percent from its 52-week high. If the U.S. economy falls into a recession MAS will catch up with the falling market and could potentially hit as low as $10. Back in 2011, the last time the U.S. economy barely kept from falling into a recession, MAS stock fell below $7. In a recession home building and improvements slow down as people either lose their jobs or postpone major purchases out of fear that they may lose their job. Masco Corp Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $26.53 $10.00 $25.00 $0.30 $0.40 3650 $4380 0.12% I will need to purchase three January put options with a strike of $25 to provide myself with the protection shown above. The next new candidate is Coca Cola Enterprises (NYSE: CCE ) another sleeper that has not been beaten down yet. The company sold all of its North American bottling operations to the Coca Cola Company (NYSE: KO ) in 2010. The current company has operations in Great Britain and much of continental Europe. When the next global recession hits, and it has already started in Europe for all practical purposes, it will be become increasingly difficult to maintain sales volume. That has already begun as sales in quarter one of 2015 were down 13 percent compared to the same period last year. Profits were down nine percent. Yet, the share price has held up nicely. I do not believe that will last as the pressure to cut prices in an effort to maintain volume will narrow the profit margins. CCE stock price on Friday closed at $51.79, only 3.7 percent off its 52-week high. I believe this is another issue that will play catch up once investors catch on. Coca Cola Enterprises Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $51.79 $24.00 $45.00 $0.65 $1.05 1900 $3,990 0.21% And now for the rest of the list. I will not go into detail on why I expect each candidate will fall as I have done so in past article at length. Readers who want to understand my reasoning better can find those details in the early parts to this series. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.28 $8.00 $22.00 $0.35 $0.50 2700 $4,050 0.150% I would need three January 2016 GT put option contracts to cover approximately one eighth of a $100,000 equity portfolio. If you already own a full position of GT options, do not exchange those for the new position. This would only add to your cost by increasing transactions. This new position is for anyone who has not yet completed their position or who may be rolling over to replace a July position. This statement applies to all of the “new” positions listed in this article. Do not trade in and out of positions to try to improve your overall position. That just defeats the purpose of keeping this strategy affordable. A better strategy is to average into a position over time, lowering your average cost basis with each purchase. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $83.31 $24.00 $70.00 $1.35 $1.90 2321 $4,410 0.190% I need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $74.51 $16.00 $60.00 $1.05 $1.70 2253 $3.830 0.170% I will need only one January 2016 TPX put options to complete this position for each $100,000 in portfolio value. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $85.71 $22.00 $70.00 $1.78 $1.99 2312 $4,601 0.199% I need one January 2016 RCL put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $69.33 $30.00 $60 $1.55 $1.75 1614 $2,825 0.175% I need one January 2016 MAR put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. E*Trade Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $25.54 $7 $20.00 $0.60 $0.65 1900 $3.705 0.195% The position shown above would require three January 2016 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $80.29 $30.00 $70.00 $1.95 $2.20 1741 $3.830 0.220% I need one January 2016 LB put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $34.21 $15.00 $28.00 $.61 $.71 1731 $3.687 0.213% I need Three January 2016 MS put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $59.58 $16.00 $55.00 $2.65 $3.10 1158 $3,590 0.310% I need one January 2016 KMX put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Sotheby’s (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $35.90 $16.00 $30.00 $.85 $1.05 1233 $3.885 0.315% I need three January 2016 BID put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Summary My eight favorite positions at this point include the two new candidates, MAS and CCE, along with BID, KMX, RCL, MAR, WSM and LB. The China problems should spill over into the BID stock performance soon. The remaining five are dependent upon a U.S. recession, which I now believe will be difficult to avoid. A discussion of the risk If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises, the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risks for a moment now. Obviously, if the market continues higher beyond January 2016, all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. If the market somehow rights itself and the bull market continues into 2016, all of these positions could potentially expire worthless unless the stock price associated with specific puts is below the strike price. It is insurance against catastrophic loss, not a get rich quick scheme. There is a price to pay for insurance. Worst case we will likely be able to scalp some more gains from MU and possible one or two others when it comes time to roll positions if the bull regains its footing. If that happens I will establish new hedge positions with expirations out to January 2017. I could be wrong, but I really do not think we will need to wait that long for the hedge to work. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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: I hold, or will purchase, put options on all the companies listed in this article.

Precious Metal ETFs Regain Shine: Will It Last?

After giving appalling performances, precious metals regained their sheen in the past couple of weeks as volatility levels picked up. This is especially true in the backdrop of growing fears over the global economy and China instability. While the U.S. economy is improving, the devaluation of the China currency and its negative impact has gripped the global market, raising fears over the global slowdown. This coupled with sluggish growth in emerging markets has compelled investors to turn their focus on precious metals as a store of wealth and a hedge against market turmoil. In particular, the global risk-off trade situation has resulted in a flight to safety to gold. Additionally, the Fed minutes dented the chance of an interest rate hike next month, leading to a decline in the U.S. dollar and a rise in gold price. Further, the growing U.S. economy is supporting the strength in silver price as the bullion is used in a wide range of industrial applications. About 50% of the metal’s total demand comes from industrial applications while 30% comes from jewelry/silverware/coins and medal manufacturers. Coming to platinum and palladium, the automotive industry, mainly catalytic converters for vehicles, is a big driver of demand. The industry is experiencing huge growth given increasing consumer confidence, rising income and of course cheap fuel. The bullish trend in the precious metals is likely to continue at least in the near term especially given the China-led global worries and the slumping stock market. Below, we have highlighted four winners from this corner of the commodity world over the past 10 trading sessions. Each of these has a Zacks ETF Rank of 3 or ‘Hold’ rating with a High risk outlook: ETFS Physical Platinum Shares ETF (NYSEARCA: PPLT ) This fund tracks the performance of the price of bullion platinum, before Trust expenses. With about $497 million in AUM, this is the largest and the only physically backed platinum product and kept in Zurich or London in plate and ingot form under the custody of JPMorgan Chase Bank. The product trades in light volume of around 32,000 shares a day and charges 60 bps in fees per year from investors. The ETF surged about 8.3% in the past 10 days. SPDR Gold Trust ETF (NYSEARCA: GLD ) This is the ultra-popular gold ETF with AUM of $24.3 billion and average daily volume of more than 5.6 million shares a day. This fund tracks the price of gold bullion measured in U.S. dollars, and kept in London under the custody of HSBC Bank USA. Expense ratio came in at 0.40%. The fund gained 5.8% in the same time period. ETFS Physical Silver Trust ETF (NYSEARCA: SIVR ) This fund has amassed $281 million in its asset base while trades in moderate volume of more than 76,000 shares per day on average. It tracks the performance of the price of silver less the Trust expenses and is backed by physical silver under the custody of HSBC Bank USA in London. Expense ratio came in at 0.30%. SIVR was up 5.7%. ETFS Physical Precious Metals Basket Trust ETF (NYSEARCA: GLTR ) For investors seeking the broad precious metal play, GLTR could be the most intriguing option. This fund provides exposure to all four precious metals in the physically backed form. Gold takes the top spot at 58%, followed by 29% in silver while the rest is almost evenly split between platinum and palladium. The product is kept in London or Zurich under the custody of JPMorgan Chase Bank. It has amassed $140 million in its asset base while trades in small volume of about 21,000 shares per day. It charges 60 bps in annual fees from investors and added 5.7% in the same time period. Bottom Line Precious metals create wealth and have been the most exciting investment area especially during times of economic and political turbulence. This is because these have value recognition nearly everywhere in the world and could easily be converted into liquid cash in any currency. The buying pressure has been intense for the precious metals lately and the most recent global economic woes have been extremely favorable for their performances. Additional buying could be in the cards for the space should tensions in China escalate. Link to the original article on Zacks

Quarterly Financial Reporting Is Needed, Productive, And Good

The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer. The cause for this article is a piece from the Wall Street Journal, Time to End Quarterly Reports, Law Firm Says . Here’s the first two sentences: Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports. Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals. The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy. I disagree. There are at least four things that are false in the arguments made in the article, and in books like Saving Capitalism from Short-Termism : Quarterly earnings don’t produce value in and of themselves Quarterly earnings cause most corporations to ignore the long-term. Ending quarterly earnings will end activism, buybacks, and dividends. Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing. Why Quarterly Earnings are Valuable I’ve written a number of articles about quarterly earnings and estimates of those earnings: Earnings Estimates as a Control Mechanism, Flawed as they are , and Earnings Estimates as a Control Mechanism, Flawed as they are, Redux . The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not. As I wrote: Most of the value of a Corporation on a going concern basis stems from the future earnings of the company. Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate. Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof. The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not. Don’t think of the quarterly earnings in isolation. A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. A bad earnings number lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. Vice-versa for a good number. Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down. They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings. In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital. When the measurement periods get too long, discipline can be lost. Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. Even if the current period’s earnings meet the estimates, the job is not done. If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. The short-term is just the beginning of the long-term. It is not either/or but both/and. A company has to try to explain to investors how it is growing the value of the firm – if present targets aren’t being met, why should there be any confidence that the future will be good? Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal. The quarterly earnings measure whether the progress toward completing the goal is adequate or not. Now, the measure is not perfect, but who can think of a better one? Ending Quarterly Earnings Would Not End Activism, Buybacks, and Dividends I can think of an area in business where earnings estimates don’t play a role – private equity. Are the owners long-term oriented? Yes. Are they short-term oriented? Yes. Is capital managed tightly? Very tightly. All excess capital is dividended back – it as if activists run the firms permanently. If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders. Activists would still analyze companies to see if they are badly managed, and in need of change. If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe. Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings. On the Use of Excess Capital Investing, particularly for the long-term, is not risk-free. In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete. In such an environment, it can make a lot of sense to focus on shorter-term investments that are more certain as to the success of the project. It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently. Companies that shrink their balance sheets tend to outperform those that grow them. As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors. The same is true of large versus small investments for organic growth away from M&A. Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing. There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not. In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. That’s how biotech firms work, and it is why so many of them fail. The few winners are astounding. Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity. All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted returns, and not wasted on speculative projects with uncertain returns. The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive. Remember, bad investments are just expenses in fancy garb – it just takes the accounting longer to recognize the losses. Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company. Conclusion If quarterly earnings are abolished, intelligent corporations won’t change much. Investment won’t go up much, and the time horizon of most management teams will not rise much. If you need any proof of that, look at how private equity and large mutual insurers manage their firms – they still analyze quarterly results, and are conservative in how they deploy capital. The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors. Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies. Disclosure: None