Markets Down… Volatility Up!

Worst start for equity markets since 2008! With more to come if you believe the prevailing view on Bay and Wall Street. Simply not enough “blood in the streets” according to the bears. Which itself is an interesting take since no one can provide clarity as to why markets had such a terrible start to the year. Aside from the obvious view that investor sentiment has been altered.

As for fundamentals we could look to slowing growth in China which over the past year has resulted in more than US $1.3 trillion of capital outflows. Some of which I suspect, has found its way into Vancouver and Toronto real estate.

The hitch with the “slow-growth-in-China” theory is that nothing is new. This is a story about an economy transitioning from its reliance on exports to one supported by domestic consumption. Such transitions create dislocations which can cause global shockwaves. However the long term strategy is rational and most economists recognize the playbook. For China to get there it needs a resilient middle class supported by a strong housing market and robust capital markets governed by well thought out rules. None of which currently exist. Still, longer term, it is the right move that will simply take time.

The oil question is more worrisome. Middle East competition for market share has removed any notion that economics of supply and demand have a role to play in this march to the abyss. The Middle East is engaged in one-upmanship of the worst kind intent on pounding ones’ enemies into submission. The oil sledgehammer being the weapon of choice.

Surprisingly Russia has taken the lead in an attempt to persuade OPEC – read Saudi Arabia – to step back from the abyss. And those efforts may work if the Saudi’s believe that curtailing production would assuage Russia to be less enthusiastic about their relationship with Iran. Time will tell!

In the meantime Canada and US oil producers are trying to survive while the Middle East clarifies its pecking order. With smaller oil producers going out of business there is real fear that it could gravely impact the North American junk bond market. To the point that some of the more vocal bears have been comparing the current situation to the one leading up to the financial crisis. I think that’s a stretch but it does explain the performance of financial stocks which have been tracking the energy sector since the beginning of the year.

What seems clear is that we are in a period of Mutually Assured Disinflation (MAD) caused in no small part by a strong US dollar and central banks efforts at quantitative easing (i.e. Japan and Europe). And despite the sharp rally on Friday I believe we will likely remain in a trading range through the first half of 2016. A thesis supported by the bond market that continues to rally in what looks like a flight to quality.

With that in mind investors would be well served to evaluate the potential downside and where possible, hedge with options when the market spikes as we witnessed on Friday. Especially as premiums remain well above their 200 day moving average.

Personally I am taking advantage of rallies to sell overpriced calls to take in cash flow through the first half of the year. Of course this should not be a static position. It may require you to to roll the covered calls up or down depending on market conditions. Should markets stabilize option premiums will contract and there may be an opportunity to close some positions at a profit. Think about it this way; you are using the covered call strategy as a hedge and not as a tool to set a target price to sell the shares.

Other hedges to consider include buying puts for insurance purposes. The problem with this strategy is that you are paying up for insurance because of the higher premiums. The alternative is to employ put spreads where you hedge to a specific target in the market. Using a spread takes volatility off the table because you are buying and selling expensive options.

Suppose for example, you believe the iShares S&P TSX index Fund (symbol XIU, Friday’s close: $18.92) could decline 10% from current levels. That would put the downside for XIU to say $17.00. You might consider buying the XIU June 19 puts while simultaneously selling the XIU June 17 puts for a debit of 65 cents.

Using the June options is in keeping with the second half story thesis. Think of the XIU bear put spread as your insurance policy with a potential profit of $1.35 versus a cost of 65 cents. If the position ends up losing money your portfolio should have increased in value by an amount that would minimize the cost of the insurance.