Neutral Outlook

The Time Horizon Chasm

Richard Croft
July 9, 2016
7 minutes read
The Time Horizon Chasm

For the first half of 2015 global financial markets have been obsessed with short term noise. We have witnessed a succession of exacerbated reactions to on again off again negotiations with Greece, waste of time debates on the timing of a Fed rate hike or endless dissections of monthly jobs data where 20% revisions are more the norm than the exception. If we can gleam anything from the first half it is the wide chasm that exists between the drivers of long and short term returns. That has not always been the case. In a normal economic environment, GDP growth, interest rates and job creation are considerations that impact both long and short term decisions. In a normal economic cycle – unfettered by central bank manipulation – analysts are able to dissect macro data and calculate its’ trickledown effect on earnings the single most important input into equity valuation. Regardless of Ones’ time horizon! In an environment where central banks are manipulating the business cycle and skewing earnings short term traders in particular, seek out alternative strategies. Note the six year outperformance of momentum stocks which excel in a low interest rate low volatility environment. Within this group valuations are propelled by new twists on old themes (i.e. Tesla) new concepts (i.e. Netflix), promising new drugs (see the entire biotech space). The problem is that a parabolic growth trajectory often leads to bubbles that have a tendency to burst under pressure from higher interest rates and increased volatility. That’s why macro events like Greece have an inordinate amount of short term influence on financial markets. When Greece settles down short term traders will turn their paranoia to the timing of the Fed’s rate hike. Not that any of this should affect long term returns but it will lead to periods of heightened volatility that will eventually be reflected in higher option premiums. So like it or not we have to pay attention. To that end let’s engage in a quick study of a Greek tragedy. What seems to be lost in the narrative is how a Greek exit would affect Germany. One could argue that Germany needs Greece more than Greece needs the Eurozone. The problem is selling that position to the German electorate. If Greece leaves there will be a period – maybe two to five years – where there will be upheaval. The Greek central bank will print Drachmas to support the economy. We may see an inflationary spike and certainly Greek exporters will be hurt. On the other hand excursions to the Greek isles will be a bargain and in time the Greek economy will settle and output will return to levels that existed prior to its inclusion in the Eurozone. It’s a much larger problem for Germany which is a country highly dependent on exports.

For the German economy to continue its growth trajectory it needs access to a large free trade zone with a weaker currency. The Euro being a weak sister to the powerful Deutsche Mark (DM). If Germany was forced to trade in DMs – the end result of a Eurozone break up – it would have a dramatic effect on German manufacturers and exporters. The problem is that German politicians cannot sell this position to its citizenry. Which means that any deal must include some austerity measures that are seen as real concessions. Greece is playing the same game but from the other side of the fence. The July 5th referendum is a sub-plot. A high stakes poker game with Greek politicians encouraging a “No” vote to give them a “Grexit” chip to improve their bargaining position. The risk is that a “Yes” vote makes it more likely other members of the Eurozone will call their bluff. I think it is highly unlikely that Greece will exit the Eurozone. Negotiations will continue regardless of the referendum outcome, cooler heads will prevail, measured concessions will be offered by the Greeks and accepted by the Eurozone, and another potential fire will be doused. Just in time for short term traders to re-focus their attention on the Fed. What this means is that the second half may unfold in much the same way as the first half. Range bound equity markets that from time to time experience short term bursts of volatility. Momentum stocks will continue to outperform assuming volatility spikes quickly abate and any interest rate hike that occurs in September or December will likely be the only one we see until 2017 or later. In a range bound scenario with intermittent short term volatility spikes covered call writing should be the ideal strategy. The problem is that low volatility makes it difficult to find opportunities that could be classified as “no-brainers!” One approach is to keep some cash on the sidelines and look for volatility spikes. You will see that during market sell-offs which I think will be buying opportunities and ideal for implementing a covered call or short put strategy. Another line of attack is to look for sectors that share similar range bound metrics but with above average volatility. The oil and gas sector delivers these characteristics as I believe oil will most likely remain between US $40 and US $60 per barrel. To that end you might consider a medium term covered call on Canadian Natural Resources (CNQ, recent close: $33.85). In this example buy CNQ and write the CNQ November 34 calls at $2.40. The five month return if exercised is 7.53%, if unchanged 7.09% and downside protection is $31.45.

Richard Croft
Richard Croft

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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