July 01, 2013 - What Should You Do When Markets Turn Flakey?
Interest rates are at historic lows as they have been for some time, and the Fed has effectively been printing money in order to keep the economy going. But with the market having seen an impressive rally this year, and with summer now upon us, market volumes are lighter and speculation rampant that the Federal Reserve is going to turn off the spigot on the free money.
So far, it seems like the Fed is managing to do Okay. If you were to give the Fed a grade like in Elementary school this handling is not an "A", but it is not an "F" either. The proper rating is somewhere in the middle—maybe "C+"? It sure would be nice if, 4.5 years since the bottom, the economy were stronger and employment were lower, so an "A" is out of the question. The economy is growing, however, and the stock market has recovered, so the Fed definitely doesn't deserve an "F."
With the market being shaky, what can investors do? Well, if the market goes down, it is best to simply be out of it. That can also come back to bite, though, if it continues higher. Certainly, it is a good time to be diversified. Diversification is always one of the best portfolio insurance strategies there is. If the market goes down, defensive stocks are a good place to be. Stocks that make essentials like toilet paper, food, medicine and drugs are usually a safe place to go.
Food remains attractive with companies like General Mills (GIS), Kellogg's (K) and Campbell's Soup (CPB). Take a look at the Kellogg's (K), the maker of many breakfast cereals including the classic Kellogg's Corn Flakes. The stock is at 63.52 and has a beta of 0.49. Now we don't usually talk much about beta, but indicator of how much the stock generally moves relative to the market. For simplicity, lets round the beta up to 0.50. If the general stock market drops Kellogg's is likely to only drop half (0.50) as much. If the market drops 6% then Kellogg's should drop 3%. The stock is expected to pull in earnings of $3.85 this year, up from $2.67 last year. The stock is expected to pay a quarterly dividend of $0.44 and carries a four STARS buys rating from S&P.
With the stock at $63.52, the December 2013 62.50 covered call has $3.10 bid. That means one can enter a covered call ($63.52-$3.10=$60.42 net debit) with 4.9% of downside protection, and a 3.4% simple assigned return over the 178 days the trade is active. Annualized (for comparison purposes only) that is a 7% return and the covered call also has a 2.9% dividend yield. Given the stocks low beta, the 4.9% of downside protection will protect against a stock market move of almost twice as much (~9.8%). They usually say the market has to drop 10% to technically be in a correction, so this covered call downside protection should protect against almost any drop up to an official correction. If the market drops more, you will lose money, but it will be less money (4.9%) less than if you had just owned the stock.
Playing a covered call on a defensive stock is like putting the frosting on cornflakes. Warning: Here it comes. We all remember Frosted Flakes from when we were a kid. "…THEY'RE GRRREAT!" It is also great getting a little more from your investments in uncertain times. If one is expecting a major drop getting out is smart, but if your predictions for the market are a little "flakey," but lacking a serious drop getting "flakey" with your investments could be one way to go!
Chart courtessy of Stockcharts.com