Energized?

Canada’s May trade deficit was 70% of the deficit recorded in April. In what seems like a good news story, in reality it was the result of imports contracting at twice the rate of exports.

The way to think about this data point is to envision a two edged sword slicing its way through the Canadian economy. Keeping in mind the always important caveat that a single data point does not a trend make.

Declining exports highlight the challenges with a stronger loonie. Note this data was being collected when the loonie was oscillating on either side of US$ par. Since then the loonie has been in foreign exchange free fall. While positive for exports, it is disconcerting when evaluating the rationale that underpinning this free fall to wit; weaker commodity prices and a general slowdown in Canadian growth. Expect more of the same as the loonie trades below the psychologically important US 95 cent level with no real support until we reach the next demarcation point at US 90 cents.

Interestingly, none of these concerns have assuaged traders, as stocks on both sides of the 49th parallel remain in rally mode. US stocks in particular were sparked by June’s employment data, which recorded the creation of an additional 195,000 jobs. Not robust numbers by any stretch, but enough to support the “slow sustainable recovery” thesis. That’s important to Canadian investors, as a slow but sustainable US recovery is ultimately good for Canadian exports.

A subtle shift towards optimism

What is becoming increasingly evident from a multitude of recent macro-economic data points is the appearance of a subtle change in sentiment, particularly in terms of how traders view data.

Earlier in the year, good news was viewed as being bad for stocks and vice versa. For example, before Mr. Bernanke released his tapering comments, weak employment data was good for stocks because it inferred Fed support for continued quantitative easing (i.e. QE III).

As that thesis wanes, traders are beginning to make decisions based on a purist interpretation of the data… where good news is good and bad news is bad. If markets are less fickle – which I recognize is a judgment call – you are in a position to offer investment recommendations on the basis of economic fundamentals rather than emotional hyperbole. If I am right, then under this new norm, scenario volatility will abate and normalize.

In that environment, you should emphasize covered calls at a time when you can collect premiums that are elevated based on current volatility metrics, and watch those premiums contract as new norm modelling becomes engrained in the investor psyche. To that end, I would focus on blue chip stocks with solid dividends, and pay particular attention to financials that will benefit from higher interest rates.

This covered call strategy will also cushion what is certain to be a bumpy transition. There remain abundant risks, particularly in geographic regions that remain underwater; notably the Eurozone, which is in the seventh month of a double dip recession. Traders are not able to simply turn off emotions that are barely below the surface. Sentiment will have a short term impact on valuations when unpredictable macro events unfold.

But a subtle shift to optimism infers that macro-economic events will take a backseat to the fundamentals that underpin second quarter earnings. Meaning that sell-offs resulting from unpredictable macro events will be short lived and represent buying opportunities.

Covered call writing also takes advantage of spikes in volatility that typically accompany sell-offs. Your objective should be to generate excess cash flow by collecting premium which should find its way to year-end performance numbers.