Archives for December 2015

PSW’s Secret Santa’s Inflation Hedges for 2016

PSW’s Secret Santa’s Inflation Hedges for 2016

By Phil Davis

Happy Holidays!

I hope you get everything you want this holiday season and, most importantly, hope you have time to spend with your family. I love waiting for my kids to wake up on Christmas morning to come out of their rooms so I can videotape (gosh I’m old, there’s no tape anymore) them in those first moments of Christmas morning – how can I not be of good cheer anticipating that?

I have something to give you for the holidays as well.  Not peace on Earth but perhaps peace of mind heading into the New Year – a way to help insure some future prosperity with a few inflation-fighting stock picks that can brighten up your portfolio, which also can be used to help balance your home’s budget against unexpected cost increases.

This isn’t an options seminar (but check out our free webinars on youtube) or one about risk or leverage – these are just a few practical ideas you can use to hedge against inflation as it may affect your everyday life using basic industry ETFs and some simple hedging strategies to give you an opportunity to stay ahead of the markets if they keep going higher.

We haven’t felt the need for inflation hedges since 2011 as the Fed has kept us in a somewhat DEflationary cycle but our 2011 hedges were good for 300-600% returns and we’re simply going to repeat the same, simple concepts here to set up rational hedges against inflation to insure a financially healthy and happy 2016:

Idea #1 – Hedging for Home Price Inflation

Let’s say you have $40,000 put aside for a deposit on a home but you’re not sure it’s the right time to buy. On the other hand, let’s say you are worried that home prices will take off again (I doubt this but you never know). XHB is the homebuilder’s ETF. It’s currently at $34.49, after bottoming out at $31.62 in August. It’s still well off the highs for the year of $39, right before the flash crash.

You can sell 2 contracts of the XHB 2018 $28 puts for $2.25 each ($450) and that obligates you to buy 200 shares of XHB at $28 (16% off the current price) and you can use that money to buy 2 2017 $28/33 bull call spreads for $3.50 ($700) and that’s net $250 out of pocket and you have 2 $5 contracts that pay back $1000 if XHB simply stays flat through 2016. These bull call spreads, however, do not pay off early – the ETF needs to be above $33 at Jan 2017 options expiration day (the 20th).

So you are putting up $250 in cash and the margin requirement on the sale will be roughly $560 in an ordinary margin account.  What have we accomplished?  Well, if XHB goes up, your $250 becomes $1000, adding $750 (300% gain on cash) to your $4,000 deposit, that should help keep you up with up to a 20% jump in home prices.

On the risk side.  We certainly don’t expect XHB to go to zero but let’s say it falls to $20 (1/3).  Well, you are obligated to own 200 shares at $28 ($5,600) and you would have lost $8 per share, so $1600 is your risk there but I would put it to you that, if we have a crash of that magnitude again, you are better off losing that $1,600 than if you had bought a home for $400,000 and had it drop 20% on you ($80,000) or even 10% ($40,000) and again, that’s a very extreme example and you are not locked into the trade, you can get out when the loss is $500, for example, keeping 87.5% of your deposit and feeling good about your decision to wait out an uncertain housing market.

gas-station-863201_960_720Idea #2 – Hedging for Fuel Inflation

Gasoline prices have dropped drastically this year and, if you are the average family, you buy about 1,000 gallons of gas per year ($2,000) and spend another $1,500 heating your home.  That’s $3,500 a year spent on energy and it’s already down over $1,000 from last year – we might want to lock that in!

XLE is the ETF for the energy market and it’s currently trading at $61.57.  If you want to guard against a $1,500 increase in the price of fuel next year, you can, very simply buy 3 Jan 2017 $60/65 bull call spreads for $2.35 ($705) and offset that cost with the sale of 2 2018 $40 puts for $2.50 ($500) for a total cash outlay of $205.  If XLE simply hits $65 (up 5%) into Jan of next year,  you make $1,295 (631% on the cash).

We can assume any increase in fuel prices over the year will push them higher and XLE has pretty much held $60 since 2010, the last time oil was below $50 that August, so this is a very nice mechanism for hedging 20% of your fuel cost.  What’s nice about this is oil can fall and you’ll save money on your fuel and, as long as XLE doesn’t fall more than 35% by 2018 – the trade only costs your $220 cash outlay and you should save far more than that on lower energy prices (assuming that relationship is maintained).  Below 35%, you get assigned 200 shares of XLE at $40 in 2018 and that’s a price that’s held up very well since 2005, when oil was under $40. So a risk of owning $8,000 worth of the Energy Spider, which puts you bullish on oil at $40 – which will always make another nice long-term general hedge against inflation.

Members at PSW know they can roll those puts or convert those put assignments into buy/writes or do a dozen other things to mitigate the losses – as I said, these are really basic examples of how anyone can hedge their real-life budgets to help them make long-range plans to fight inflation.

Idea #3 – Hedging for Food Inflation

If you think you spend a lot on fuel, maybe you haven’t been to the grocery store lately. I knew food inflation was getting out of hand when the A&P’s fruit and vegetable prices started catching up with Whole Foods. I used to get a few cool items at Whole Foods and stop at A&P for the staples but there’s barely a difference in fruits and vegetables anymore when it used to be extreme. Good for Whole Foods and local growers, but not so good for the average consumer who is being bled dry by commodity speculators and agriculture cartels.

And the middle-men are getting crushed too. A&P (GAP) went bankrupt and DF has flatlined with WFM down for the year, even after a spectacular pop in December. Perhaps the CEO’s of Dean Foods and Whole Foods can benefit from this hedging exercise as well.

DBA is the way to go here.  It’s been a while since we’ve liked them when they shot up early in 2014 from $24 to $29 and, since then, it’s been straight downhill back to $20.48, where we love them on the long side again.

If you spend $10,000 a year on groceries you can risk being assigned 400 shares for $8,000 and sell 4 of the 2018 $20 puts for $1.25 each ($500).  That money can be used to buy 8 of the 2017 $20/23 bull call spreads for $1.15 ($920) and that’s net $420 out of pocket (2 week’s shopping) and the upside, if DBA simply hits $23 (up 7%), is $2,400 less the $420 laid out –i.e. $1,980 — so a 20% hedge against food inflation and your risk is owning 400 shares of DBA at $20 ($8,000) as a long-term hedge – if food prices continue to go lower.

The 2018 put sale, if DBA should go to $16 (down 20%), would cost you $1,600 – less than you will probably save on food.  Remember, these are not magic beans that pay off no matter what the market does – these are hedges against inflation and, if there is no inflation, then you will save LESS than you otherwise would have but, again – there are dozens of ways to make owning DBA long-term a successful part of your portfolio.  Instead of randomly investing your retirement savings – trade ideas like these are ways to put some of the money to work for you – in ways that can help you manage your bills NOW – as part of your daily life.

Inflation Hedge #4 – Hedging Against Rises in PSW Member Fees

We run a unique service.  I am on-line most trading days chatting live with members about trades.  Optrader and Trend Trader and several of our other writers are online as well but there is a limit to how many people we can effectively get back to in a day so we limit our Membership and, when it gets too crowded, raise our prices (we just did last year).

For 2016, let’s make things interesting with my favorite hedge. If you sign up for a full year membership between now and Jan 2, 1016, AND the following trade idea does NOT net 100% on the cash outlay by expiration day on Jan 2017, then I will give you a free Membership for 2017!

(Probably good time to put in some kind of contest disclaimer that this is just for fun and we guarantee nothing at all and that we can change the rules at any time and that we accept no responsibility for anything under any circumstances whatsoever – how’s that?  I just want you to know how good I feel about this trade idea. Always consult a professional investment advisor (I’m not one) before doing anything!)

Anyway, what’s the trade? VERY simple on NATURAL GAS! I just wrote a post on why I love UNG down here (was $7 at the time, already $7.69) and UNG Jan 2017 $5/9 bull call spreads for $2 can be offset with the sale of Jan 2018 $7 puts for $1.60. That will be a net cost of $0.40 for the $4 spread plus the put obligation (we are not counting the margin amount). The payout if UNG reaches expiration at $9 (now $7.69) is $4 – or 900% more than the $0.40 outlay.

To make 100% on the cash ($0.40), the net price of that spread has to be $0.80 or greater – that’s the “bet.” Obviously, if the spread is even a penny over $7, the $7 puts would expire worthless and will not be an issue and, at $7, the spread returns $2,000 for each $400 invested (10 contracts).  Remember, if it fails to return at least 100% and you have signed up for an Annual Membership in the next 7 days – you will get a free year in 2017.

Now, if you are thinking, after going over these ideas and seeing how a few of our old trades worked out: “Well, that’s too easy, there’s a very good chance of making 100% on that trade.” That’s kind of my point!  That is the point to using options and hedging in a balanced virtual portfolio and that is what we teach over at PSW every day.

I very much hope all these trades work out well, ESPECIALLY the last one!

Have a very happy holidays and we hope to see you inside in the new year.

All the best,

– Phil

Sticker Shock: Fed to Hike Rates First Time in NINE Years!

Sticker Shock: Fed to Hike Rates First Time in NINE Years!

Courtesy of Phil’s Stock World

A rate hike – what’s that?

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It has been so long since the Federal Reserve has raise interest rates in the US that Banks and Brokerage houses are having seminars for their workers to help them understand the repercussions of a rising rate environment.  If you are working with Mortgage Brokers or Financial Planners under the age of 35 – then it’s very possible that in their entire professional careers, they have never been in an economic environment like this.  Even for the older market professionals and traders, it’s been so long it’s hard to remember.

The Fed last began tightening rates back in June of 2004 mainly to cool a rapidly rising housing market but also to cool off the “irrational exuberance” in the stock market, as the S&P had gone from 800 in August of 2002 to 1,300 in April of 2006 (up 62.5%) while housing prices had doubled off their mid 90’s lows.  The pace of that tightening was 1% every six months, topping out at 5.25% 2 years later:

As you can see – it had a bit more than the desired effect on the housing market though housing prices continued to go up all the way into 2006 before completely collapsing almost all the way back to where they were 10 years earlier – a real “lost decade” for home buyers.  Only then did the ripple effects spill out to the stock market and it was the mortgage lenders themselves and the Financial Institutions that traded their collateralized debt that ultimately took the economy down.

It would seem the Fed has gotten smarter and is not going to even let a runaway housing market get started this time – and that’s a smart choice as we sure can’t afford another round of bailouts, and the low rates have let most homeowners survive the downturn, albeit without the gains they hoped they would make from their housing investments.

Since our September, 2011, lows on the S&P at 1,100, the S&P has climber 950 points, which is 86.3% and Janet Yellen has already said that’s a bubble she is wary of.  It’s very doubtful that the Fed will tighten as aggressively as they did in the 2004-6 cycle and a big thing we’ll be watching today is what kind of signals they do give as to their future intentions.  As I mentioned on Monday, Hilsenrath (the Fed Whisperer) has already prepared the faithful for a gentle, gradual tightening process but we’ve been at almost zero for so long – almost any increase will seem huge to spoiled borrowers.

As rates rise, the Trillions of Dollars of Corporate Bonds that were purchased as low rates will begin to lose their value on the secondary market.  Verizon (VZ) for example, sold $49Bn worth of 5% debt (all at once) in 2013 and has since refinanced it at even lower rates.  That’s great for VZ but it won’t be so good for people holding 5% and lower corporate bonds as “safer” Treasuries begin to rise to match the yields.

Anyone with a portfolio knows a loss is a loss when you are staring at it and, with 10-year notes at 2.15%, heading to just 3% will knock the value of $2Tn worth of corporate bonds down by 10-20% on the resale market. We’re talking $200-400Bn in paper losses on somebody’s balance sheet!  Although, it’s no sure thing as yet, 10-year notes jumped 33% when Greenspan first began tightening in 2004 but they went back down several times as no one really believed the high rates would last 10 years (and they were right!). At the time, Greenspan called it a “conundrum.”

Another thing that happens in a rising rate environment is home refinances dry up very quickly. Obviously, no one wants to refinance their loans for higher rates and that will prevent people from taking money out of their homes leaving less money to spend in the economy. Home sales will also come under pressure as mortgage rates rise.

This could be the end of 0% financing on cars, furniture, etc. as well as teaser rates on Credit Card Debt and $1.3Tn of student loans are geared to the Fed Funds Rate – making them harder to pay off with those minimum wage paychecks.  With Corporations cut off from easy cash, we may finally see a decline in stock buybacks and M&A activity and that, of course, will not be a positive for the markets.

According to the WSJ, $541Bn has already been withdrawn from risky Emerging Markets in 2015 and the Fed hike may push that number much higher.  Corporate Debt Ratios in emerging markets have jumped by 30% of their GDP in the past 5 years – clearly an unsustainable pace and potentially a disaster as the rollovers become more and more expensive. That’s why, so far, the Fed is the lone wolf among Central Bankers in moving towards raising rates. Others are still looking to go lower, some EU Banks are already negative.

Back in September, the IMF’s Christine Lagarde begged the Fed to wait until 2016 to raise rates “because of the implications for developing nations.”  Lagarde said that she is concerned that many emerging markets may have expended their capacity to buffer against shocks in the wake of the financial crisis.  In a much-ignored IMF report back in October, it was esimated that Emerging Markets have over-borrowed by roughly $3Tn:

The IMF estimates developing nations—led by China—may have over-borrowed by roughly $3 trillion, and is warning that those countries could face a wave of corporate defaults. The fund estimates around 25% of China’s corporate debt is at risk, especially in the real estate and construction sectors, and including many state-owned firms.

That “will unavoidably entail some corporate defaults, the exit of a number of nonviable firms, and write-offs on nonperforming loans,” they said.

We are, of course, already seeing those defaults begin to hit – this is why we went short China at the dead top on April 9th (FXI was $51.24, now $35.64 – down 30%) and I was banging the table to get out of China all that month.  In fact, we noticed that Chinese bond defaults were becoming a problem early on:

I know, I sounded like a broken record. If I got just SOME people to get out of China before it all collapsed, then it was worth it. In May (and that last post was 5/2), we finally had a little scare in China and then it rallied but then it completely and utterly collapsed, never to recover (so far), yet the US markets have been chugging along (and we are “Cashy and Cautious” on those now).

Another factor to consider is currency valuations. If the Fed hikes while others remain at ease, then the Dollar may get stronger against other currencies (it’s already at 10-year highs). That puts more downward pressure on commodity prices (priced in Dollars), with many Emerging Markets depend on commodities to survive.  While it’s good for their exports, it also devalues any bonds they sell in their local currency as the relative value of bonds priced in Euros, Yen, Yuan, Aussie Dollars, Loonies, etc. falls compared to bonds priced in greenbacks.

Remember, China did everything it could to prevent a collapse and it still happened.  How do you think other countries will do if faced with the same pressure as defaults begin to rise?


Note: The Fed is in a particularly bad spot. As Paul Price and I wrote in August this year,

[A]ny increase in rates this year will be small, perhaps around 0.25%. Apart from a short-lived reaction by day traders, a small increase in rates is unlikely to have a major effect on stock prices. Even post-rate hike, absolute rates will be low. Income producing alternatives will still be scarce. The lack of risk-free returns drove indexes to higher than average P/E ratios in the first place. A small rate increase won’t change that.

When “safe” investments yield next to nothing, “risky” investments, like stocks, become more appealing, even when the S&P is near its all-time high.

The price of the SPY alone does not determine the best place for new money. The attractiveness of alternatives is also important. And as for new money, many central banks are in “printing” mode. Due to the lack of alternative investments, the demand for stocks has kept US equities almost constantly moving higher. The demand has also lowered the risk of holding stocks. Huge corporate buybacks, using cheaply borrowed money (available due to ZIRP) has further diminished supply while boosting demand.

Only significantly higher rates would break this pattern. But there’s a problem with that.

America’s greater than $18 trillion, and growing, national debt suggests that significantly higher rates are not coming anytime soon. A 1% nominal increase on the average coupon rate that Washington pays would add about $180 billion per year to US’s annual debt service expense.

Raising money to pay off growing government debt, exacerbated by rate hikes, would force the issuance of even more debt. The US, unlike Greece, can and will continue printing money. The money printing (issuing more debt) would inevitably lead to much higher inflation. As many have said more succinctly, we cannot cure an unpayable debt load by issuing more and more debt. The cost of servicing that debt would become a true budget buster. (Opportunity Vs. Risk in a Bifurcated Market)


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