Monthly Archives: March 2017

Lightly Held Opinions

The last post was about my then view of an on-going intermediate correction. I went at length explaining why even have an opinion and the extent of my conviction. I felt I need to further clarify given the recent market actions and my own activities.

The market proved more stubborn than the technical indicators or at least my interpretations led me to believe. In fairness any projections are inherently probabilistic in nature. The refusal to break down and the bounce yesterday have led me to consider the possibility that the “April bounce” originally framed within the context of the intermediate decline may instead produce a new high. Though I still see the decline in May-July bringing us below where we’re currently.

As mentioned, my timing moves to the extent of a 12.7% cash position in the active accounts were “incidental” to the portfolio realignment due to tax considerations. It’s never my plan to trade around an intermediate decline of weeks to several months in duration, especially in the larger context of what I believe will be a memorable bull market. The fact that I’m buying individual stocks rather than the whole market gives more flexibility. As such today I added to BAC, and existing position; and opened a position in MO. Both are at or below their 50 DMA due to recent weakness. The purchases were short of the final intended size.

I hope I have illustrated the nature of my market predictions: they are opinions with a rationale basis that I can defend, but I’m not married to them. I fully accept that I’ll be wrong as often as right; and when the market proves me wrong, I change my mind. There’s nothing to prove, no intellectual battle to be won. My ego won’t provide for my family. In the end, I rather be making money than being right.

A Correction May Be Upon Us

The long waited correction may be finally upon us. The 1%+ drop in the S&P on Mar 21st was the first in over 100 days. The bounce on the 22nd was anemic and accompanied by low volume. Most of today (23rd) was spent in positive territory but sellers took over in the last two hours — a very tell-tale sign. As in the chart below, we have broken below the trend line from the November election. Given this evidence, I’m of the opinion that an intermediate correction of months in duration has started.

I’ll go out on a limb again in trying to forecast a duration and depth of this correction. My model is signaling a bounce in April and a resumption of decline in May with a hard drop and bottom into July. I have little confidence in the exact path but a correction of 4+ months in duration will match that of the rise, a symmetry that would be appealing. The Fibonacci levels for this “Trump rally” aligns nicely with regions of minor support/resistance. I don’t trade at those time intervals but it’s interesting nonetheless. Given the nature of the in-flows of this rally, and that the market is never kind to Johnny-came-latelies, there is a high probability we’ll retrace all the way to the November bottom and more. I would go so far as saying that the “Brexit” bottom of 1991.68 is also in play.

Why do I bother with this kind of predictions and what do I plan to do with that information anyway? First and foremost it’s to develop a feel for the market and secondly to build confidence in the model. I’ve been clear on my approach to market-timing. My main goal is to be able to avoid the “big one” and ensure that my family is provided for. The skills that I’m honing are essential in deciphering the macro trends.

Since the inception of this blog, my most significant market timing move, in terms of duration and amount of capital, was the avoidance of nominal bonds. 35-40% of my passive portfolio has been in stable value funds paying 2 or 3% per annum. It’s been a good move — AGG has lost 3% since Aug’16. Compared with that that my pruning of stocks is rather opportunistic. In full disclosure, my pace of selling picked up in Feb/Mar, but it was not due to my market view. The main reason was the rotation in my fixed income allocation precipitated a desire to limit dividend payouts. This morning I closed out the MCD/DIS option spreads mentioned in this post, along with a couple other positions to give me a 12.7% cash position in my active portfolio. I don’t have plans for more sales; instead there are 7-9 buy candidates. My longer term view remains that we are in a full-blown bull market; but first, we’ll have to wait out this correction.

Financial Independence Progress Report

Financial Independence is a term you see a lot these days, but the definitions vary which is problematic. On the Reddit Financial Independence forum, it is defined as the combination of assets and other income streams that together generate a passive income that covers one’s basic living expenses. The level of assets is typically derived from the 4% rule. Then there are others that require the passive income to cover one’s current standard living expenses. It is this latter more stringent definition that I subscribe to. To make matters more confusing, there is the notion of “retire early (RE)” which together with FI makes the catchy FIRE. In principle, RE can happen at any time, but more commonly RE is concurrent with or follows FI.

I’ve always like this progression of financial milestones from Radical Personal Finance:

Stage 0
Financial Dependence
Stage 1
Financial Solvency
Stage 2
Financial Stability
Stage 3
Debt Freedom
Stage 4
Financial Security
Stage 5
Financial Independence
Stage 6
Financial Freedom
Stage 7
Financial Abundance

See the original post for definitions. So where am I on this journey? Below I’ve put my own “numbers” around the terminology. I couldn’t help patting myself on the back for what we’ve achieved in 15 years after my first “real job”. I’ll admit to having indulged in some Excel porn in coming up with the target dates of the future milestones; but hey, that’s the most fun anyone’s going to have with MS Office, right?

Disciplined savings and prudent financial decisions were largely responsible for our initial success but going forward the returns should matter a lot more. 2016 saw our highest income to-date but the contributions were still overwhelmed by the returns; and 2017 will be a below-average year in terms of bonuses. Equal if not a greater concern is to limit draw downs as the dollar amounts will be large and I’ll have less time to make them up. Hence the allocation to PMs, CEFs that are night and day from TBM, market timing moves, etc. While a large chunk of my passive portfolio is something even a Boglehead might approve of, the overall portfolio is probably as complex as an individual, non-professional investor can make it. I realize it’s not for everyone, God knows it took me two decades to get to this point. I’m still learning and evolving and my portfolio will too. That’s the fun part.

Model Predictions, Mar 2017

I first spoke of the equity pricing model I follow in this post last November. Though I don’t plan on giving the details of the model, I do want to give updates as projections evolve. The model is but one input in formulating my market narrative, though an important one.

Last November, the model was signaling a dramatic final bull phase for this market, to the extent that I was willing to put a price target AND a time, which I’ll no doubt live to regret, namely S&P of 3400 in Q4’18. Updating with more recent data and some fine tweaking later, the model is still forecasting a sharp upward trajectory but also a little more volatility in 2018. The predicted peak is still a very respectable 3000+ in the S&P and the timing has been extended into 2019. There wasn’t much change in 2017 where I still expect the S&P to end the year with a 27 handle.

There is negligible impact on actual investment decisions — being directionally correct is can be asked for anyway. I have already carried out the slight increase in equity allocation in my passive portfolio, discussed here and here. I’m in the middle of a more dramatic over-haul of my active portfolio that I’ll go into in a future post. There is a final batch of stocks to buy and sell; the greater quandary, as always, is the timing. The market has been running hotter than the model predictions — a small correction from April to July has been anticipated, besides there are other voices calling a correction in May.

The most sensible course of action seems keep writing near term puts on the stocks I’ve picked out and let the market come to me.

Anatomy of an Options Trade

Owning individual stocks rather than an index ETF affords many more opportunities to sell option premia as a way to generate some side income. I generally avoid covered calls since most of my holdings are intended for long-term. The implied volatilities are usually higher for puts anyway. My preferred modus operandi is to sell cash-secured (margin-secured really) puts on stocks that I don’t mind owning. That said, the timing and strike are such that the vast majority expire worthless. The position size is so small that I only aim to generate a couple percent per year of the eligible securities in my main trading account. 20-30% returns are not unheard of for those who are serious at it.

This post, however, describes an on-going high-conviction, directional bet the likes of which I increasingly look to as the conviction in my forecast grows. BTW, to put S&P 3400 in Q4’18 into perspective, a 27 handle is implied for the end of 2017.

McDonald’s (MCD) was the underlying stock and the two trade dates were indicated by the blue vertical lines. On 8/23/16, MCD was around 113 after falling from a high of 128 in May. RSI was showing a small negative divergence (lower low but RSI higher), the following option spread was opened:

Two Jan’18 125 strike calls were bought, financed by selling a 110 put of the same expiration. It was a net credit transaction for which I received $80 minus the $2.66 commission. Since MCD had a lot of downside momentum I got a good price on the just out-of-money put. I got the idea for this spread from synthetic equities (buying a call and selling a put at the same price) and synthetic equities with split strike (to ensure a net credit transaction normally). I had to use very wide split strikes (110/125) to get the 2:1 ratio. It was indicative of an extremely bullish bias.

Jan’18 was the furthest expiration available at the time. Since it was a net credit transaction, I was never worried about time decay and I wanted the furthest out options to make the trade work. As MCD continued to drop this trade was underwater until the start of the “Trump rally”. On 2/13/2017, MCD touched 125, the strike price of the calls and I conducted the following trade:

I swapped 3 130 strike calls for the 2 125 strike calls for $30 and moved up the put strike from 110 to 120 for $283 credit. In total, the transactions carried a net credit of $253 minus the $6.20 commission. I’m still long these 3 calls and short 1 put that together have a current market value of $1200+. Not too shabby considering it’s been all credit transactions from the get go. Of course it was not riskless — downside risk being defined by the short put.

I haven’t engaged in many similar trades. There is one with Disney that’s almost a carbon copy. A more recent split strike synthetic equity (non-ratio) position in Gilead is up but losing steam. There was also an earlier trade with Novo Nordisk that was closed with a loss. My conclusion is it’s all about timing. The hope is the favorable market environment will skew the chances to the upside.

Update: The option spreads in both MCD/DIS were closed on 3/23/2017. All were Jan 2018 LEAPs. They were put on as credit transactions so time decay was not a problem initially. However, as the trade started to work and call ratios were increased there were a lot of time premia to lose if there was a correction of several months duration. I kept the synthetic equity position in GILD using Jan 2019 LEAPs.