Opportunity and Risk in a Crazy Market
This is one nutty market. After crashing 34% into bear market territory in record time, it has come almost all the way back in record time. The S&P 500 closed Monday less than 5% from the all time high and in positive territory for 2020.
That’s hard to believe. What happened to all this coronavirus lockdown stuff? Haven’t we been stuck at home for almost three months now? The economy is getting destroyed by a self-inflicted, government imposed lockdown. Major banks are calling for a 40% contraction in second quarter GDP. That’s worse than the Great Depression.
But the market loves it.
That seems strange. But it’s not as out-of-whack as you may think. The stock market is a “leading indicator” that typically looks ahead six to nine months, and trades according to that anticipated situation. It sees an economy that is making up for lost time and absolutely booming by then. And the market is usually right.
To put this flash crash and flash recovery in perspective, consider this. In looking ahead, the market typically moves ahead of the economy. Historically, it tends to anticipate a recession before the economy actually turns south, and goes down before the economy. Then it usually starts to turn higher before the economy bottoms because it anticipates recovery around the corner. But the process got skewed this time.
The market didn’t move down ahead of the economy because it couldn’t anticipate the pandemic. That’s why it made up for lost time and fell 34% in record time. Because the recession is self inflicted by government mandated lockdown orders, it should recover quicker than a normal recession when those restrictions are lifted. So the market quickly moved from the bottom in anticipation of a recovery around the corner.
The unusual government imposed economic crash followed by the removal of lockdown restrictions is resulting in a highly accelerated recession and recovery process. Naturally, the market reflects that unusual and highly accelerated process.
But I’m still wary of the market here.
I don’t doubt that the economy will come roaring back. It’s also true that the Fed has pledged to back up the market if it turns south again with more stimulus. But the market is already pricing in a very positive scenario that may not unfold.
The virus could come back as the economy restarts, and delay the process. Everything could go great for while and then the virus could spread again later in the year. Sure, the market is most likely generally correct about the future economic recovery. But it doesn’t seem to be pricing in the clear and present risks.
While the overall market may have gotten frothy, there are still pockets of great opportunity. Certain companies are facing little or no business disruption as a result of the lockdowns. In fact, some companies are thriving while the stock prices are still well below the pre-virus highs.
I identified three such stocks in the inaugural issue last week. These are companies with growing businesses that aren’t being disrupted in the recession, sell at discounted prices and have high yields that are safe. So far, they’re doing great.
The very first issue of Cabot Income Advisor became available on June 2nd. In that issue I recommended the purchase of three stocks, Altria (MO), AbbVie (ABBV) and Innovative Industrial Properties (IIPR). They weren’t chosen because they had the highest yields available, but rather because they offered strong yields along with downside resiliency in the event of another market downturn.
So far, so good. All the stocks have had a nice move higher in the past week. IIPR is up 3%, MO is 6% higher, and ABBV has had an 8% up move. I also recommended the selling of a covered call on IIPR on June 3rd via a “special alert” email. Here is the email.
Sell IIPR July 17 $95 call at $3 or higher
Expiration date: July 17
Strike price: $95
Call price: $3 or higher
The stock price has moved 6.8% higher over the last week and 19.4% higher over the last month. The upward momentum in the stock has lifted the sale price. The stock is currently just below $90 per share. The strike price of $95 provides a fair amount of upside.
The first issue of Cabot Income Advisor just came out yesterday. The idea is to sell a covered call, meaning you already own or you just purchased IIPR on the buy recommendation. A single call option represents 100 shares of the stock. I suggest you sell the amount of call options that reflect your underlying stock position. For example, if you own 500 shares of IIPR, sell 5 calls.
I will assume you purchased the stock at $90 per share. Here are the return possibilities.
1. The stock goes above $95
Call premium: $3.10
Dividend: $1.23 (the pay date is July 14th)
Appreciation: $5 ($95 strike price minus $90 purchase price)
Total: $9.33 (total return will be 10.37% in six weeks)
2. The stock price stays the same
Call premium: $3.10
Total: $4.33 (total return will be 4.81% in six weeks)
3. The stock price declines
You will be down by how ever much the stock is down less the $4.33 from the dividend and the call. And the position will live to pay more dividends and write more calls in the future.
In the future, I will not show the entire “special alert” in the weekly update. But since it is the first one, I want to make sure you see it. Call options are extremely price sensitive and are unlikely to be at the exact price I identify by the time you receive the alert and execute the trade.
In this case the $3.10 call price was likely lower than you should have gotten. I targeted the price at $3 or higher. But if you executed the sales later in the same day, you probable got closer to $4 for the call. That same call is now selling at $5.60 as the stock price has moved higher. If you haven’t sold a call on your position yet, I recommend you do so now at an even better price.
AbbVie Inc. (ABBV) Yield 4.9% — AbbVie is absolutely one of the best large pharmaceutical companies on the market. It is cutting edge in its drugs and treatments and has one of the very best pipelines of new drugs in the industry. At the same time, the stock is cheap and it has the highest yield of any big drug company.
The stock got hammered as investors worried about increasing competition for its blockbuster drug Humira. I believe the concerns are overblown because AbbVie has some of the best new drugs and a strong pipeline that can compensate. Investors had realized the value before the bear market and the stock ran way higher. It has now come back and exceeded those levels.
Although ABBV has just made a new 52-week high (at 98) it is still well below the 2018 high of 140. I’m dying to write a call on this stock but I’m holding off for now. Usually when a stock makes a new high it tends to run a bit higher and I want to wait and write a call at a higher strike price.
Altria (MO) Yield 7.84% —The stock price of this beleaguered cigarette maker has finally broken out a little bit. After wallowing between 35 and 40 per share during the market recovery, it finally broke to about 43 earlier this week. That’s a pleasant surprise. Although the stock is a great value with a high and safe dividend yield, I wasn’t counting on a lot of appreciation. But it looks like investors are getting wise. I believe the stock has little downside risk and a stratospheric yield. Keep your eyes open. I will likely write a call on this stock in the near future.
Innovative Industrial Properties (IIPR) Yield 4.2% — Marijuana is a huge growth business. And the prospects for further legalization get better by the day as states grapple with huge budget shortfalls during the pandemic. They will likely be desperate for more tax revenues going forward. Innovative is a rare marijuana stock that is actually making money now, and lots of it. In fact, earnings are projected to grow 88% this year, and at a similar level in future years.
This stock can be volatile. It’s up about 4% from the June 2nd price but it had gone much higher over the course of the week. The stock had run all the way above 98 on Monday but has pulled back to about 91. Despite having moved above the 95 strike price, you won’t have the stock called unless it is above that price when the option expires on July 17th.
This stock tends to be volatile with the market in the short term. The price will likely go down if there is another market selloff. But I believe the story is so good that it will be worth the volatility and come roaring back again. In the meantime, you can continue to collect the dividend and write more calls on the stock.