The Start of our Summer of Discontent

by JDH on July 3, 2010

I suspect that since this is a long weekend in both Canada and the United States, virtually no-one will be reading these words. That’s fine, I write these weekly ramblings entirely for my own benefit; it’s my way to force myself to keep an eye on the markets, and my portfolio. That being said, I am pleased to report, to myself, that the plan continues to unfold as expected.

But first, it’s time for an update on our 2010 Predictions, made last December. I am pleased to report that my prediction for the Dow, on June 30, 2010, was 10,000, and it actually closed at 9,774, so I get the “closest to the pin” award. As for the gold price prediction, I predicted $1,350, and it actually closed at $1,243, so I was close, but the “closest to the pin” award goes to our perennial winner, Davidslane, who predicted a gold price of $1,180, only $62 off the actual closing price. Congratulations.

Now, back to our regularly scheduled programming.

As I have repeated for many weeks in this space, I don’t think the summer will be pretty. This week was a preview of our summer of discontent. In summary:

1 There ain’t no jobs. This is a “jobless recovery”, which of course is an oxymoron; you can’t have a recovery without jobs. On Friday the U.S. Department of Labor released the June Labor Report, and it was not pretty. Here’s the quote:

Total nonfarm payroll employment declined by 125,000 in June, and the
unemployment rate edged down to 9.5 percent, the U.S. Bureau of Labor
Statistics reported today. The decline in payroll employment reflected
a decrease (-225,000) in the number of temporary employees working on
Census 2010. Private-sector payroll employment edged up by 83,000.

Of course these numbers are “cooked”. It’s mathematically impossible to lose 125,000 jobs (including 225,000 jobs lost now that the temporary Census workers are no longer taking the census), and yet have the unemployment rate “edge” down to 9.5 percent. Well, it’s not mathematically impossible if, for some reason, in the month of June, 652,000 Americans left the Civilian Labor Force (you can find that number on Table A). So there you go. A lot of jobs were lost, but even more people decided to simply stop working, so the unemployment rate improved.

Fortunately, some members of the Main Stream Media actually figured this out. The Los Angeles Times reported that Unemployment rate dips as more workers leave labor force, which is a perfect summary of the “good news” about the unemployment rate “edging” down. In other words, it’s not good news at all.

2 The Baltic Dry Index, which is a generally reliable measure of shipping activity, is tanking, and looks ready to approach the lows in the depths of the recession from November, 2008.

3 Government deficits around the world are really, really big. That’s not good. Even worse, all of the massive stimulus spending of the last two years, has, quite predictably, done no good. You can’t simply print money and expect paper to increase wealth, just as an individual can’t go on a credit card spending spree and increase their wealth. Governments are power hungry, which makes them stupid, which is the cause of our current mess. (See items 1 and 2 above). And for a real laugh, check out some lady named Nancy Pelosi who thinks that the solution to all of our problems is to send out more unemployment insurance checks, because that will create jobs. What a nut.

4 The oil spill in the Gulf continues to spill away, with no end in sight. It is now obvious that BP and the government have no idea how to stop it, so we can assume it will continue to flow for many months to come, increasing the disaster, and increasing the economic repercussions. Real estate prices in the area will plummet, which isn’t good for the economy.

5 Real estate prices are plummeting. In Florida, 81% of homes are “underwater”, meaning the property is worth less than the outstanding balance on the mortgage. That’s a disaster.

6 An Israel-Iran war now appears inevitable. This is not a political blog, so I won’t elaborate on the reasons, but it appears that military action will start within the next two weeks, with July 11 looking like the likely date. Let’s hope I’m completely wrong on this one.

7 Gold continues to make new highs. Yes, I know, there was that little hiccup on July 1 where gold crashed $44, or 3.5% in one day. Gold was treading water right up to 10:00 am on Thursday, and then the Big Boys (JP Morgan) overwhelmed the market with sell orders, presumably to do some short selling. That’s fine; made for a good buying opportunity. All of their suppression efforts have kept the price low, but it hasn’t lead to a correction, so that’s good news for gold investors, but very bad news for governments that want to hide the fact that they are printing money. (Investors realize that printing money diminishes the value of the currency, forcing investors to flee to gold as a “safe haven”).

So, the summer won’t be pretty. It might get very ugly. So how am I playing it? With a relatively simple approach.

First, I am holding more cash than normal. In a deflationary environment, cash is king.

Second, while I have no doubt that gold will rise substantially in the medium to long term, the outlook for the traditionally weak summer period is less rosy. So, I am holding my gold and silver stocks, but to reduce my risk I am using a covered writing strategy, where I sell call options against shares I own.

As I reported last week (Gold and the Markets: Exactly as Expected) on June 25 I sold options covered by stocks I own. I sold July call options, around $1 out of the money, on:

With the collapse in the gold price on Thursday, my gold stocks took a beating. That’s fine, that’s just a temporary hiccup, but it made the options strategy work beautifully. Here’s the summary:

What does this mean in real money? Here’s an example, with dollar values:

Each options contract represents an option to buy a lot of 100 shares. So, one contract of the Agnico-Eagle July 66 call sold for $1.30 would net $1.30 x 100 = $130. If you own a block of 1,000 shares, you can “cover” those 1,000 shares with 10 contracts, so your net proceeds before commissions would be $1,300. Each brokerage account will be different, but let’s assume the commissions on the sale were $22.49, so that leaves net proceeds to me of $1,277.51. So, on June 25, I owned my shares in AEM.TO – Agnico-Eagle Mines Ltd., which was selling for around $65, and I had sold the option on those shares to someone who could buy them from me for $66 anytime up to options expiry on July 17.

Then, on July 2, I re-purchased those options for 49 cents. So, it cost .49 x 10 contracts x 100 shares per contract, or $490 to re-purchase them, plus the $22.49 commission, for a total cost of $512.49.

That puts my net profit at $1,277.51 – $512.49 = $765.02

Of course the only reason I could repurchase the options for less than I sold them for was because AEM.TO – Agnico-Eagle Mines Ltd. fell from around $65 to around $62, so you could argue that the correct course of action would have been to sell the shares on June 25 and avoid the $3 per share loss. However, I can’t pick the exact tops and bottoms, and long term I plan to own the stock. I assume it will recover, so I’m satisfied to have reduced my cost of ownership by $765.02 / 1,000 shares, or 76.5 cents per share.

The results on the other shares are similar.

If we have another run up in gold early in the week, I may cover my shares again, with more July calls. Obviously the premiums won’t be as high, since a week’s worth of time premium will have eroded, but it’s possible that there will be more gains to be had. Even if it can’t be done again, do the math:

If the share price were to remain unchanged at $65, and if you could generate 76.5 cents per month writing calls against the stock, that would be an annualized return of 14%. That’s not bad at all. Of course if the share price remained unchanged the option premiums would be lower, so these profits would not be possible, and of course the share price won’t remain unchanged. However, if you cover after three solid up days, and then “Buy to Close” after the inevitable corrections like we experienced on Thursday, you can certainly mitigate some risk, and feather your nest at the same time.

Finally, back to the market. I continue to believe that the market is headed down, and this week’s action didn’t change my mind. The long term support level of around 1,040 on the S&P 500 going back to last September was broken this week, and that’s not good news if you are a bull. With the RSI at 30 a short term bounce early in the week is quite possible, but I’m betting on 900 before we will see 1,200.

I continue to hold a few shares of the RSW – Rydex Inverse 2X S&P ETF, an ETF that goes up when the market goes down. I don’t have a large holding, but it’s there as short term insurance.

Second, with play money, I am also buying puts. On June 24 I bought some August 1000 SPX puts; I paid $22 for them, and then sold them the next day for $24. I put a buy order in again on Monday at $19, and didn’t get filled, which was a tragedy, since the market had a big correction on Tuesday. I would have come close to doubling my money. Oh well, can’t win ’em all.

On Tuesday I bought more August 1000 SPX puts for $31, and then sold them on July 1 for $38. A nice profit, but not what it could have been.

In an effort to reduce my exposure, on Thursday I dropped down a notch on bought the August 900 SPX puts for $15; at the close on Friday they were worth around $12, so I’m down on this trade so far, but there’s still time, so I’m holding.

Again, let me emphasize that doing covered writes by selling options against stocks you own is a relatively conservative strategy. Buying short term options is essentially gambling, so you would be a fool to do it with anything more than a few dollars that you won’t miss when you inevitably lose the whole bundle.

We shall see how July progresses; I suspect we will look back thirty days from now and marvel at how much worse things got.

I hope I’m wrong. If I am, no problem, I’m holding cash, so I’m not concerned.

A belated Happy Canada Day to my fellow Canadians, and a Happy Fourth of July to my American readers. See you next week.

{ 0 comments… add one now }