Whatever you think about the directions of the market, or the potential gains versus the potential dangers, you can’t keep a heavy cash allocation forever. At some point you have to put it to work.
While I’m talking about market direction, Raul Pal said something interesting the other day that stuck with me – essentially that even though many are gearing for it, we’re not going to have a liquidity event. The federal reserve is determined to make sure that their measures of liquidity – in the bonds markets, money markets, and so on – are met. Take this as an illustration:
The high yield corporate bond index is trading at 81 vs 85 a year ago and 88 at the recent peak. So it’s down about 5% on the year, down 8.5% from the peak, and it prices in an annual yield of only 5.5%. This is at a time where we’re hearing about bankruptcies such as Hertz, JC Penney, and so on. The federal reserve has a number of “special purpose vehicles” designed to jump straight into this market if they feel the need to, and they routinely jump into the much more liquid commercial paper and government debt markets to keep plenty of cash available for borrowing.
So are we out of the woods? Not exactly, because we still have a major solvency event on our hands. Debt levels were at all time highs before the crisis – most recently used to fuel the largest corporate stock buyback boom ever, but also used for a number of other questionable investments which don’t necessarily provide cash-flows to cover those debts. Then the Covid-19 shutdowns struck, crippling many industries and causing a spike of unemployment never seen in our lifetimes.
The government reacted quickly, shooting out $1200 stimulus checks to all citizens (I just got mine and deposited it during this last week), and providing greatly enhanced unemployment benefits to recently displaced workers. These recently unemployed will keep paying their rent and their bills as long as the money comes in, but what happens after that? The economy won’t restart like a car engine with all those workers going right back to work at concert venues, casinos, bars, airports, hotels, and so on – it will take much longer than that for these jobs to return. Many businesses such as restaurants previously needed to be working near full capacity to make a profit, so bringing them down to reduced capacity will require substantially lower rents which works through to other parts of the chain.
I really think that we’re potentially entering a new normal that more resembles post-1989 Japan. Deficits will soar, the central bank will keep rates low and its balance sheet will balloon, but we will still have strong deflationary forces working through. The stock market will likely do what it always does – respond with a hyper-focus on liquidity. If the federal reserve tightens, stocks will fall, then they’ll loosen and stocks will shoot back up. This makes for a bad-news-is-good-news environment where anything that encourages the central banks and politicians to spend is bullish, and anything that allows them to take their foot off the gas will cause the stock market to falter.
So – back to putting money to work. Last Friday as gold miners and silver soared, I ended up selling off all of my long option positions in those. Monday had a pullback, where I jumped in from a more defensive standpoint – buying shares and selling in-the-money covered calls immediately. As the week continued, I kept this going but with dividend paying stocks (most recently PPL). As the Russell 2000 revisited the post-covid highs, I tiptoed back into 2022 puts there as well. My shorts are down percentage-wise though as their value is simply lower.
Anyway, here’s my latest allocation:
- 16.5% Cash
- 10% Shorts (puts)
- 1% Long (calls)
- 39% Gold miner stocks with in-the-money covered calls
- 33.5% Dividend paying stocks with in-the-money covered calls
The way I see it, you have to be nimble to make money in today’s markets. That means you have to be able to form an opinion of the risks and the market direction, and adjust your stance accordingly.
If you’re really bullish – like I was with good miners a few weeks back – then you can express that by holding stocks or even long-dated options. If you’re bearish then long-dated puts can work but you will be fighting the fed so be careful and hold more cash on hand. If you’re thinking flat to minor pullback, like I am now, then covered calls are the way to go.
Note that many portfolio managers stick with covered calls as an overall strategy, and there’s something to be said for that. It is no silver bullet however, because the stock market can be volatile and this essentially caps your upside while largely keeping the downside risk. If the market goes down and back up, just like the S&P 500 from 9/2018-4/2019, you won’t gain your losses back. So stay nimble, stay engaged, and stay active.