Options as Insurance

Richard Croft
September 12, 2011
11 minutes read

Reams of economic data has come down the pike since the end of August. And most of it painting a very bleak picture!

The New York-based Conference Board’s Consumer Confidence Index, a widely-watched monthly gauge of consumer sentiment in the US, sank to 44.5 in August, down sharply from a reading of 59.2 in July, and well off a high of over 70 registered earlier this year. According to the Board, the August reading was the lowest in two years.

It’s not surprising that US consumers are feeling a bit down in the mouth. A weak housing market and lack of a good job will do that. US unemployment remains above 9% and despite efforts to stimulate activity, will likely remain above that level for the remainder of this year and well into next.

The US Dept. of Labor’s monthly payroll report didn’t help either. According to that report, there was no growth at all in non-farm payrolls in August. Which is to say “no new jobs!” In addition, these numbers get revised more often than politicians create new committees. And most of these revisions have been to the downside (note: July’s numbers were revised down to 85,000 from 117,000). If these downward revisions continue, August could conceivably end up showing a net loss in jobs. If that, in turn, is followed by net loss in September, the US economy would officially be in recession.

More fuel for the fire came from the Institute for Supply Management’s (ISM) August purchasing managers manufacturing index. The index posted a reading of 50.6 in August, down from 50.9 in July. As bulls are quick to point out, a reading above 50 indicates expansion (50 being the threshold between growth and contraction).

The bears, on the other hand, will tell you that the August reading is just the latest in a long string of declines for the index. And this is not a US phenomenon as manufacturing everywhere has been slowing, and in some regions of the world is actually contracting.

The eurozone, for example, saw its manufacturing index drop to 49 in August. The only reason it didn’t drop further was that German manufacturing stayed on the right side of 50, with a reading of 50.9. Germany was the only eurozone country to show manufacturing growth for August. The UK manufacturing index slipped to 49, shrinking the most in 26 months. And the HSBC Purchasing Managers Index for China posted a reading of 49.9 in August, up slightly from the 49.3 logged in July.

The pattern here isn’t terribly encouraging, as manufacturing is an important barometer of economic activity, reflecting very quickly trends in consumer demand and global trade. With these under pressure over the past few months, markets have become understandably underwhelming, discounting future growth expectations through present value adjustments on financial asset prices. Okay, that’s just econo-babble for falling prices, of which we’ve seen plenty in both equity and commodity markets in recent weeks. So much so that equity markets have been “correcting” since the third week of July.

The one anomaly in this otherwise uniform picture of economic gloom is Canada. While overall second-quarter economic growth sputtered into a slight contraction of 0.4% annualized, Canadian GDP actually expanded in June. And Canadian manufacturing grew in August, as measured by the RBC Canadian manufacturing purchasing managers index, which rose to 54.9 from 53.1 in July. According to the RBC survey, new orders came in at the fastest pace since April, while businesses raided inventories and ramped up production to fill orders. In the process, new hiring saw a boost, which will contribute to job growth in coming months.

Some of Canada’s anomalous manufacturing growth can be attributed to a recovery from severe supply chain problems resulting from the Japanese earthquake in March, which led to production slowdowns in the auto sector. In addition, energy production is returning to normal following production disruptions arising from wildfire outbreaks in Alberta earlier in the year.

But really… can we expect that pace of growth to continue, given the slowdown globally, and given that much of Canada’s economy is trade-driven, and most of that coming from US. It’s hard to imagine manufacturing growth in Canada if its largest trading partner is slowing and likely to continue the downward path for the reminder of the year.

And speaking of trade, Canada’s current account deficit widened again in the second quarter, as Statistics Canada reported that the deficit rose by $5.3 billion, to $15.3 billion in the period. Essentially, a trade deficit means that the country imports more goods, services, and investment income than it exports. The account has been in deficit for the past three years, with no relief in sight as long as the Canadian dollar remains strong and US demand remains weak.

It’s no wonder that the Bank of Canada kept its benchmark lending rate at 1% last week, saying that the “global economic outlook has deteriorated in recent weeks.” And while most observers concentrated on that statement, the Bank’s outlook for the second half is perhaps more telling: “Largely due to temporary factors, Canadian economic growth stalled in the second quarter. The Bank continues to expect that growth will resume in the second half of this year, led by business investment and household expenditures, although lower wealth and incomes will likely moderate the pace of investment and consumption growth.”

Fortunately, US rating agency Fitch kept its AAA rating on Canadian sovereign debt, pointing to a “culture of conservative policymaking” and “strong political and social commitment to balance the budget.” It forecasts total year GDP growth of 2.3% for Canada.

None of this mattered to the markets of course. Most global markets fell on Friday, and while there were many plausible reasons for the fallout – economic gloom, central bank uncertainty, etc. – the culprit that stands out is the eurozone.

The eurozone crisis deepened again last week with the resignation of yet another German member of the European Central Bank’s executive board. Add to that reports that German financial authorities were readying plans to re-capitalize German banks in the event of a Greek default, and investors got into a selling state of mind.

Rumors continue to swirl about an imminent Greek default, although hotly (and naturally) denied by the Greek government. However, the increasing reluctance of many eurozone countries to write another cheque to the Greek government in the face of its inability to meet EU-imposed budget targets is rapidly hardening into policy. That’s nowhere more evident than in Germany, where opposition parties are poised to topple Angela Merkel’s ruling coalition in elections later this month. Merkel is unlikely to martyr herself and her party for the sake of keeping Greece in the eurozone. The risk of a Greek default has now ratcheted up considerably.

Even the Swiss National Bank, worried about the effects of huge hot money flows into its currency has pegged the franc at 1.20 to the euro. The Swiss have vowed to defend that position with “unlimited” purchase of foreign currency. When ultra conservative regimes make such statements investors would do well to pay attention!

Given the inherent risks and the lack of any positive news on the immediate horizon, investors might want to take out some insurance to protect against further downside risk and increased market volatility.

The purest insurance play is to simply buy puts on broad based indices like say the iShares S&P/TSX 60 Index Fund (TSX: XIU, Friday’s close $17.75). Specifically look at buying the XIU October 17.50 puts at 60 cents per share.

Another approach is to look at writing covered calls against XIU, assuming you own the shares. In this case, look at selling the XIU October 18 calls at 45 cents per share. In fact, you might want to look at covered calls on some of your stock positions, particularly if you own banks, energy and manufacturing companies.

One other approach is bear call spreads on the XIU. Say, selling the XIU October 18 calls at 45 cents and buying the XIU October 20 calls at 5 cents for a net credit of 40 cents per share. You could do worse than create cash flow in your portfolio during periods of heightened risk.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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