Snapshots from the Edge

I have always believed that a picture is worth a 1,000 words. It certainly makes life easier for writers, allowing them to explain so much more with so little input.

Two charts come to mind. The first was on my OED presentation but does not show up on the presentation that can be downloaded from this blog. That chart compared the ten year performance of the S&P TSX composite index relative to the S&P 500 index. I encourage anyone to re-produce that chart at any good charting site. The bottom line is that both the Canadian and US markets started and ended in lockstep over the last decade.

The second chart that does appear in the OED presentation, which can be downloaded from this blog, looks at the two year performance of the same two indices. The divergence in the two indices is testimony to the impact quantitative easing has had on the US equity markets.

The dramatic out-performance in the US equity markets should lay to rest any lingering doubt as to the impact the Fed’s largesse is having on the financial markets. Considering the longer term correlation between the two markets and the inevitability of mean reversion, it implies one of two scenarios; 1) the Canadian market will rally playing catch up or 2) the US market will pull back as QE-III begins to unwind.

None of this infers a market rout, although should the upcoming US debt ceiling debate get ugly, it could lead to a more serious US pullback caused by a shift in sentiment. If so, Canada would be a good defensive play and the Canadian banks – as we talked about previously – might be the best defense against a hostile bear.

Another defensive position is to write long term covered calls against high yielding utility stocks with good cash flow. BCE Inc. (TSX: Friday’s close $43.44) comes to mind. The stock is yielding 5.36% and management has consistently raised the dividend since the Ontario Teachers’ Pension Plan backed away from plans to purchase the company at the height of the financial crisis. Taking a portfolio view, BCE is an interesting alternative for income assets in your portfolio. Think of a BCE Inc. covered write instead of say, a mid-term corporate bond.

For example, you could buy BCE Inc. at $43.44 and write the BCE May 44 calls at $1.35 per share. If the shares are called away in May, your return is 7.32%, which includes two dividends of 58.5 cents, plus the $1.353 per share premium, plus 56 cents per share in capital gains. If BCE Inc. is unchanged through May, your return is 5.99%. The premium also provides some downside protection to $42.09.

Not exciting for some traders, but when you consider what you would get from a mid-term bond over the same period, the BCE Inc. covered call is an interesting alternative as a defensive asset in your portfolio.