Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.

Q4 2014 Forecast

Here is my latest forecast of the S&P 500 quarterly averages. The market is quite a bit above what profits would justify, which means the PE ratio is expanding, or to put it another way, people are so desperate for earnings that they're willing to take higher risks. The market is above the forecast as it was in the late 1990's bubble.

Swedes help with timing

Anyone not a mainstream economist has recognized the awesome blindness of the profession to the approach of the latest financial crisis and its impotent policies afterwards. I recently finished a book published last year that not only explains why mainstream economics failed but promotes good economics, the Austrian kind, and provides another tool for telling the future.

Thomas Aubrey, the author of Profiting from Monetary Policy and founder of Credit Capital Advisory in the U.K., consults businesses on how credit creation affects global asset prices. Aubrey begins by detailing the devastation of the crisis on pension funds. Not only did many funds lose money in the crisis, but the low interest rate monetary policies intended to restore the economy have inflicted more damage and will lead to many failing in the future. Aubrey doesn’t mention the life insurance industry, but it and millions of retired people are suffering for the same reasons.

Austrian Bull Riding

Earlier this year Doug French, a senior writer at Agora Financial wrote a nice review of my book, Financial Bull Riding. In case you haven't read the book, this might persuade you to take the ride:

How Austrians Ride the Financial Bull

By Doug French

The single most asked question I get at investment conferences is, “Do you have a list of money managers who invest guided by the Austrian School of economics?” The question is a good one. After all, the Austrian School stands alone in predicting the fall of the Soviet Union and the housing and financial crash.

Anyone with a retirement account has been whipsawed by the stock market over the past few decades. Fidelity’s Peter Lynch told everyone to buy stocks and hold. Everything would work out great. Diligent savers would even end up millionaires, courtesy of an ever-expanding stock market. The efficient-market hypothesis (EMH) provided intellectual support for the idea. The market reflects all information, so there’s no way to beat it, said the economists.

Another Omen - Price to Sales

The first indicator most investors check in order to begin to assess the value of the overall stock market is the price/earnings (PE) ratio, which is currently around 18 and just slightly higher than the 60-year average of 16.3. 

But the PE ratio can change a lot depending on the number of years one selects to calculate the average. For example, the Schiller ratio uses a 10-year moving average and calculates the ratio at 26.3. As the last post disclosed, corporations have been buying back their own stock and that alters the ratio by reducing the number of shares divided into profits. 

Who is buying?

The Dow is back over 17,000 and the S&P 500 topped 2,000 again this week. Who is buying at these nose bleed levels? According to Jeffrey Kleintop of LPL Financial the buyers are individual investors and corporations buying back their own stock (Hat tip to Christopher Rowe, Director of Investor Education at The Oxford Club). 

Currently, there are six notable trends in buying and selling in the stock market. U.S. stocks are being purchased by corporations and individuals; however, foreigners, hedge funds, institutions and insiders are net sellers.

According to data from FactSet, S&P 500 companies bought back about $160 billion in stock in the first quarter of 2014, and are on pace for an amount this quarter that is close to the all-time high of $172 billion set in the third quarter of 2007. Corporations have been decreasing the amount of shares in the market for 10 straight quarters. Over the past year, this has amounted to about 3% of shares outstanding in the S&P 500. 

Why does this matter? Individual investors tend to pile into the market near the top so that they buy high and sell low. Individuals are a small part of the market, so they function mainly as an indicator that the end is near.

Corporate buying is a much larger segment, large enough to overwhelm institutional selling and cause the market to rise. Corporations are borrowing to purchase their own stocks and pump up returns. This deflates the price/earnings ratio by inflating the earnings per share. So while I'm not a big fan of PE ratios as a guide to investing, corporate buy-backs make the ratio even less worthwhile.

But the main problem with corporate buy-backs is that the corporations are borrowing to buy. That pumps up the price of the stocks, makes management look better and in some cases triggers options and bonuses for them.

Kleintop expects institutional selling to continue. So what happens when profits go south and corporations have trouble making the payments on the loans? It will take out the largest group of buyers in the market this year. Most will have to sell the stocks they bought for a loss. That will accelerate any decline in the stock market that follows a bad earnings reporting season.

Entrepreneurs in the Big Short

Michael Lewis is the bestselling author of many books, but the first one I have read is The Big Short: Inside the Doomsday Machine, which is about the financial crisis of 2008. Lewis’ economics is terrible, but I still recommend the book.

First the terrible part: Lewis doesn't understand good economics, by which I mean Austrian. From the book I would guess he doesn't know much mainstream economics either. If readers really want to understand the mechanics of how the crises unfolded I would recommend Slapped by the Invisible Hand by Gary Gorton. In a nutshell, it was an old fashioned bank run in which depositors got scared that their deposits were in danger and pulled their money out of the bank. Only in this case the depositors were money market mutual funds, pension funds and insurance companies and the banks were the large investment banks like Lehman and Bear Stearns. But what even the Slapped authorGorton doesn't tell readers is that the run began because of the collapse in the price of housing. It wasn't lightening out of a blue sky.