Friday, May 17, 2013

The Fed, QE, the Economy and Goldilocks 2.0

It was never easy being a central banker and the job has become much more difficult over the course of the last five years or so, but right now the task of guiding monetary policy and juggling the myriad of threats to economic stability is particularly daunting.

Take the Fed, for instance. The current policy statement calls for $85 billion of bond purchases each month, until the unemployment rate is below 6.5%, as long as inflation expectations do not rise above 2.5%.

At some point, however, the Fed will have to taper its bond purchases and ultimately begin selling some of its bond holdings. The big questions surround when to begin reversing course and how dramatic the increments will be in those policy changes.

With the unemployment rate and rate of inflation highlighted as the key data points for determining the timing and magnitude of the policy changes, the task of slowing and ultimately reversing the quantitative easing policy seems reasonably straightforward, at least in theory.

One big problem is that the unemployment rate may not be a very good gauge of the health of the economy. The chart below shows economic data reports relative to expectations over the course of the last 3 ½ years. Note that up until about a year ago, there was a very strong correlation between the performance of the S&P 500 index and whether economic data beat or missed consensus estimates. The correlation resumed when economic data turned up in the end of September, but a new divergence arose when economic data began stalling about two months ago, while stocks have been making new highs.

[source(s): various]

Looking at the five components of the economic data, one can see that for the past eight months or so there has been a favorable trend in housing/construction, employment, the consumer, and prices/inflation. As the graphic below illustrates, the one category that has been consistently missing expectations, particularly over the course of the last five weeks, has been manufacturing and general economic data, a category that includes reports such as GDP, ISM, Industrial Production, Capacity Utilization, Durable Goods, Factory Orders, Regional Fed Indices, Productivity, etc.

[source(s): various]

The problem for the Fed is that even though even though the consumer, housing / construction and aggregate unemployment rates all suggest an improving economy, the manufacturing sector and employment measures such as the labor force participation rate (official BLS graphic) paint a picture of continuing economic weakness.

As an investor, one has to guess how the Fed will handle this evolving conundrum. My general sense is that bulls will be rewarded if the economic data continue to fall slightly short of expectations and help to persuade the Fed that maintaining or perhaps even increasing bond purchases is the best policy approach – all of which should be a positive for stocks. Should economic data, particularly the employment component, begin to top estimates on a regular basis then we are left with the likely conclusion that the Fed will begin to remove the QE safety net relatively quickly. At the other end of the spectrum, if data fall well short of expectations going forward, the more perplexing conclusion is that even with its expanding toolbox, efforts by the Fed to prop up the economy are having at best a temporary effect and are also demonstrating diminishing returns. For investors, the data sweet spot going forward – or Goldilocks zone, if you will – is likely to be a series of near misses that extends the current policy indefinitely.

[Readers who are interested in more information on the component data included in this graphic and the methodology used are encouraged to check out the links below. For those seeking more details on the specific economic data releases which are part of my aggregate data calculations, check out Chart of the Week: The Year in Economic Data (2010).]

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Disclosure(s): none

Thursday, May 16, 2013

ETPs Turn to Selling Options to Generate Income

Not long after I penned The Options and Volatility ETPs Landscape, Credit Suisse (CS) added another buy-write / covered call ETP to the mix: the Credit Suisse Silver Shares Covered Call ETN (SLVO).

With SLVO, Credit Suisse is essentially extending the methodology they pioneered with the Credit Suisse Gold Shares Covered Call ETN (GLDI). In the case of both GLDI and SLVO, the ETPs are selling covered calls against the underlying commodity ETF for gold (GLD) and silver (SLV) in an effort to generate some income, and in so doing, choosing to forego some upside potential. In both instances, the ETP starts selling covered calls with 39 days until expiration and completes the sales with 35 days to expiration. One month later, the ETP buys these covered calls back over a period ranging from five to nine days prior to expiration. The net proceeds of these covered call transactions are then paid out as a monthly dividend. This dividend payment is not guaranteed and can fluctuate substantially from month to month. In the first four months following its launch, the monthly dividend for GLDI has been 0.1146, 0.0724, 0.1319 and 0.0572.

As silver is generally much more volatile than gold, SLVO elects to sell calls that are 6% out-of-the-money, while GLDI sells calls that are only 3% OTM. Other than this difference in strike selection or moneyness, the strategies employed by GLDI and SLVO are essentially the same.

Of course, covered call strategies work best when the price of the underlying is flat or when the underlying is appreciating slowly. During the recent sharp drop in GLD and SLV, the covered calls did provide a small amount of downside protection, but with GLD falling 13% over the course of just two trading days last month, the downside protection offered by a covered call was barely more than a rounding error. Covered calls and buy-write strategies generally outperform a long position in the underlying in all instances except when the underlying experiences a strong bull move.  (See graphic below for details.)

Thinking more broadly, the introduction of GLDI and SLVO should reinforce the idea that with ETPs now spanning a wide variety of asset classes and alternative investments, covered call strategies can be implemented in many non-traditional ways. The most popular of the traditional methods is PowerShares S&P 500 BuyWrite (PBP), which sells covered calls against the popular equity index. There is no reason, however, why there cannot be a similar product that sells covered calls against more volatile groups or sectors, such as emerging markets (EEM), small caps (IWM) or semiconductors (SMH), just to name a few. One can even bring alternative assets under the covered call tent. I’m not talking just about the likes of crude oil, copper or corn, but why not have covered calls on real estate, currencies or even volatility ETPs?

Better yet, why stop at covered calls? A strategy that I have discussed here on a number of occasions is selling cash-secured puts. The recent launch of U.S. Equity High Volatility Put Write Index ETF (HVPW) brought the put-write strategy into the ETP marketplace.  It is unfortunate that put-write strategies have not found a wider audience at this point or they too would be ripe for extending beyond the comfortable confines of the S&P 500 index.

Assuming this market eventually stops going up almost every day, investors are going to have to look for other ways to grow their portfolio and the scramble for yield will no doubt intensify. With ETPs now selling options to generate income, investors may want to look at some of the shrink-wrapped products mentioned above or consider how they might wish to implement similar strategies on their own.


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Disclosure(s): long GLDI and HVPW at time of writing

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