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The Protection Game?

Richard Croft
May 24, 2011
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It seems that the world did not come to an end on the week-end. Something that was being promoted by a group of religious zealots who were predicting the end of times… commonly referred to as the “Rapture.”

Of course, one could argue for an apocalyptic event, if the peripheral Eurozone countries cannot find the political will to put their economic house in order. Not that we haven’t known about the fiscal irresponsibility in Portugal, Italy, Ireland, Greece, and Spain (famed for the PIGS acronym) for some time. But now analysts are focusing on the problems, or more specifically, the lack of concrete solutions. Greece being the tip of the iceberg when it comes to lacking political will.

The concern is that Greek politicians continue to play their violin while Greece burns, and as time moves on, the contagion is spreading. Specifically to larger economies whose fiscal woes would have a more catastrophic impact on the world stage. Read Italy and Spain.

US investors took notice of Italy’s debt woes on Monday, as the US stock market tumbled (the TMX was closed for the holiday). And to add fuel to the fire, there were the “everything is fine” musings from Portugal’s Finance Minister. He was touring the US in search of new investments, which is a sure sign that things in his country are anything but alright! In fact his interview on CNBC sounded a lot like the President of Bear Stearns trying to spin a positive tale about his company just before it went bankrupt.

In light of contagion fears, we are likely see a period of heightened market volatility. In all global markets… including Canada! And without the prospect of further easing by the US Federal Reserve (i.e. QE III which we may yet see), there will be a period of slow growth, and more likely, a market correction.

In my opinion, the options market has not fully priced in the risks. Which means there is still time to take defensive measures. Because option premiums are still reasonable, buying index puts is one stop gap approach, should the worst occur. Look at the iShares S&P TSX 60 Index Fund (symbol XIU, Friday’s close $19.63) September 19.50 puts at 70 cents as a reasonable insurance policy.

A better insurance policy would be the US Federal Reserve actually embarking on QE III. In that scenario, the excess liquidity would artificially prop up the market until stability or a Eurozone solution is found. Of course, that’s not the right approach, but politicians being politicians, it is an approach that helps win elections.

Assuming you are in the QE III camp, then you could write covered calls on stocks in your portfolio. Again not the best strategy when premiums are low. But while QE III might support the market, it will not likely stimulate a surge in North American stock prices. As such, selling covered calls can provide limited cash flow while you wait.

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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