Late last week, on the first day of summer, I watched the news and weather for a few minutes before my morning run. It was 85 degrees with 97% humidity. It was 4:40am. The meteorologist said the “feel like” temperature was 99 degrees.
I ran anyway. It was awful. Such is life on the Gulf Coast this time of year. We can count on a lot of things, including heat, storms, and mosquitoes. And we watch out for bigger things that are possible if not certain, like hurricanes.
I’ve lived through my fair share of the latter living on both sides of the Gulf. We have “go bags,” backpacks filled with a few essentials, and we’ve identified what we’d take in terms of files, photo albums, and computers. We’ve never implemented the plan, but I don’t mind spending the time and money on it because the cost/benefit analysis is compelling.
This year I’ve got a few more things to worry about, like our new golf cart rental business on the coast. In the event of a storm, we’ll need to get 30 golf carts over to storage, which is no easy task. And I’ve got my house on the market. If you’re not a coastal dweller, you might not know that insurance companies won’t write new coverage on a home if there’s a named storm swirling around. It could be 1,000 miles away, but that doesn’t matter.
This is where the old axiom about separating what you can control from what you can’t comes to mind, and it brings me to the markets.
Current State Of The Markets
We’re in a protracted trade spat with China, but the Chinese economy was already slowing before that started. U.S. manufacturing has eased back to almost even between expansion and contraction, and both the Federal Reserve and ECB are signaling easy money ahead.
Banks earn about 2.37% lending to each other overnight, which is more than the 2.01% they can earn if they bought 10-year Treasury bonds. The yield curve is partially inverted.
The initial bump from tax reform is fading. The Atlanta Fed’s GDPNow model shows GDP growth falling from 3.1% in the first quarter to 2.0% in the second.
Earnings season is almost here. Corporate earnings fell 2.3% in the first quarter and, in March, analysts expected second-quarter earnings to decline 0.4%. They’ve now revised that number lower, to -2.6%. Third quarter earnings estimates have been revised from a slight gain to a slight decline.
And the equity markets are near all-time highs.
One of these things seems glaringly out of place…
I’m far from knowing exactly when the markets will top, roll over, or zoom ahead. Those calls fall into the “I can’t control” category. But I can make well-educated forecasts borne out of research and experience.
And that’s why I believe it’s time to make sure your equity market “go bag” is packed and ready. It will cost you something, but it could save you a bundle.
Your Equity Market “Go Bag” Inventory
I’ve reminded people repeatedly to stick to their trading strategies, like we do in Boom & Bust. Stop loss levels can save you from enormous pain, so tighten those up. But in terms of overall market insurance, nothing beats a simple put option strategy meant to overlay your broad accounts, including your retirement accounts.
I just checked on the SPDR S&P 500 ETF, trading at $294.40. I can buy a December 2019 put with a 294-strike price for $11.38, or 3.8%.
Here’s the problem: If the markets keep climbing, this option will lose value. If the markets remain flat, this option will lose value. If the markets fall, the option will gain intrinsic value, but it will still lose time premium.
It sure sounds like a lose-lose-lose! Unless the equity markets fall more than 3% or so in the next couple of months…
Luckily, options don’t lose time premium in a straight line. They tend to lose the most time premium in the last 60 days before they expire, so this would be in November and December, or if the underlying asset (the S&P 500) has moved substantially away from the strike price.
If the markets rocket higher, then this option will lose value quickly, but your equities will be moving higher. On the flip side, if the markets roll over in the normally difficult months between July and October, you’ve got protection.
It could mean the difference between holding on to double digit gains for the year or riding the markets back near the flat line.
No matter what happens, the reason to buy a December contract is so that you don’t have to hold it all the way to expiration and live through the last month or two when time premium decays so quickly. Instead, you can protect yourself during late summer and early fall, and then sell the option while it still has some time left.
Just like insuring your car, health, or home, you can face a little bit of financial pain today and hopefully stave off a lot of potential pain in the future.