Equities have been on a tear of late, with the broad-based Standard & Poor’s 500 Index up in seven of the past eight weeks. Growing evidence that the financial sector may not be as troubled as many had thought has certainly helped fuel the rally, as has recent data that suggest that the economic downward spiral is starting to level off. The question on the minds of many investors now is whether we’re at the early stages of another bull market or in a bear market that’s destined to re-test the March lows. Indeed, this is a critical question for us, too, since our expectations for the market determine which options we write in our Model Covered Call Portfolio; the portfolio contains five options that expire this month and another five that expire in June. (See figure 1 on page 4 for a snapshot of our portfolio at the close of trading on April 30th.)
An Economic Spiral That May Be Stabilizing
According to the Bureau of Economic Analysis, the U.S. economy, as measured by GDP (gross domestic product), contracted at an annual rate of 6.1% in the first quarter of 2009. This figure will undoubtedly be revised a few times in the weeks ahead, but the final number will probably approximate the 6.3% decrease posted in last year’s closing quarter. The economy’s performance over the past two quarters represents the worst six months in some 50 years. That said, data released over the past few weeks suggest the deterioration is decelerating and the current quarter is off to a slightly better start. The Institute for Supply Management, for example, reported a slight improvement in manufacturing activity in April, and a survey by Reuters and the University of Michigan showed a modest brightening in consumer attitudes. Moreover, on May 4th, the Commerce Department reported an unexpected increase in construction spending (after five straight monthly declines), as well as a surprising 3.2% increase in pending home sales.
A Sizzling Stock Market
Stocks were in a free fall in 2009’s opening months, with the S&P 500 Index slumping 8.6% in January and 11.0% in February. Indeed, the market seemed to be sinking into an abyss in the early days of March, as investors contemplated both the nationalization of America’s largest financial institutions and a stock market plunge that seemed to have no bottom. By the ninth of March, stock prices were at levels last seen in the fall of 1996. In the subsequent eight weeks, however, the S&P has soared more than 34%, rising 8.5% and 9.4% in March and April, respectively; it also gained 3.9% in the first two trading days of May, moving into positive territory for the year. Word that Citigroup (C), a major recipient of government bailout money and the principal subject of nationalization speculation, was “profitable” in January and February ignited the two-month-long rally. The current surge has also been fueled by enthusiasm over Treasury Secretary Timothy Geithner’s recently announced plan for absorbing banks’ toxic assets, the aforementioned economic data, and first-quarter corporate earnings that have generally topped expectations.
Our view in the closing weeks of 2008 was that the stock market had either already seen the bottom or was very close to one. Moreover, we expected a recovery in equities to be both gradual and choppy, considering the global economies’ myriad problems. We positioned our portfolio for this environment by writing mostly close-to-the-money calls, as had been the case for several months. As it turned out, the heretofore market bottom was still ahead of us, but this strategy, along with a recovery in some of our beaten-down long stock positions, allowed us to weather the storm well in January and February; the shares of Genco Shipping, for example, are up 50% since the beginning of the year, and we booked solid profits in Schering-Plough and IBM (IBM). The value of the portfolio actually increased in both months, rising 2.1% and 0.2%, respectively. The portfolio lagged the soaring benchmark index in March and April, though, which wasn’t surprising since the worst environment for writing covered calls, at least compared to simply holding stocks, is a strongly bullish market. It still performed well on an absolute basis, advancing 5.7% in March and 7.9% in April. Significantly, year to date, through the end of April, our Model Covered Call Portfolio is up 16.7%, compared with a deficit of 3.4% for the S&P 500 Index, an advantage of some 20.1 percentage points.
Indications that the economy’s downward spiral is leveling off is certainly encouraging, as, too, is the improvement in consumer confidence. Moreover, the economic data over the next several months should show further progress, as tax rebates, the implementation of the Obama Administration’s $787 billion stimulus package, and decades-low mortgage rates support increased business activity. That said, we’re not yet ready to jump into the bullish camp for a variety of reasons. More than five million Americans have lost their jobs since the ongoing recession began in late 2007, and data due out in a few days will probably show an unemployment rate that is approaching 9%, the highest in more than 26 years. Banks aren’t out of the woods yet as a growing number of commercial loans are souring, and first-quarter results wouldn’t have looked so good without some easing in accounting requirements. The manufacturing sector remains under considerable pressure, as the world’s auto makers will attest; April sales plunged 34%, and every major manufacturer reported dramatic year-over-year declines, despite offering huge financial incentives. Note, too, that tax rebates and stimulus spending yield a one-time boost that will prove ephemeral without an improvement in macroeconomic activity or additional stimuli, which will become increasingly difficult as the federal government’s debt load soars to astronomical proportions. As for the better-than-expected March-quarter earnings, they were still mostly well below year-earlier levels, reflecting the aforementioned job losses, anxiety about the future, and a broad retrenchment by Americans after sustaining an $11 trillion hit to their net worth in 2008. This backdrop is hardly the prescription for a V-shaped economic recovery or another meaningful bull market. This doesn’t mean that we think we’re in the midst of a bear market rally, either. The recent strength, in our view, represents, largely, the correction of a market sell-off that was driven by panic selling and liquidation. Looking forward, we envision an economy that scrapes along the bottom for an extended period of time. This would probably support a stock market that wouldn’t deviate too far or too fast from current levels. In other words, we think stock-picking will be critical for the foreseeable future, and the environment will be good, not necessarily ideal, for writing covered calls. At the end of April, five of our 20 call positions were in-the-money, and six were within 5% of their respective strike prices. We’ll probably try to maintain a similar posture as we roll out our options later this month and in June.