Time to write covered call options

The Bank of Canada was right to hold off on cutting the prime interest rate but sunny government inflation statistics and industry forecasts are deceptive. Edward Gardiner, an Ottawa-based market observer and frequent contributor to Investor’s Digest of Canada, says stagnation may be the best we can hope for in 2016. He suggests selling covered call options on the big five Canadian banks as a smart investment strategy for 2016.

While I am not as pessimistic as the Royal Bank of Scotland, which is calling for 2016 to be a total disaster and advising its clients to sell everything and hold only high-quality corporate bonds, I do believe that 2016 will be a bad year for investors.

Mind you, that’s coming off a year that saw a recession in Canada for the first half, followed by a stock market correction which prompted many stock prices to drop 20 per cent or more.

Even “quality” high-dividend stocks like banks and utilities have taken a hit. I don’t think share prices have reached bottom yet. There’s more bad news to come and there’s nothing governments can do to prevent it.

Economic growth in China is slowing, and is non-existent in most of the rest of the world. The price of oil continues to drop, along with the prices of most other natural resources; from lumber to coal to potash (all of which are major industries in Canada).

The U.S. economy is showing some signs of life, but it only looks good because the rest of the world is doing so poorly. In addition, the U.S. (and almost everyone else) still has to work through the massive increases to the money supply from years of quantitative easing.

One faint ray of hope is the fact that the Bank of Canada did not lower interest rates in January.

Pundits had been predicting that they would for weeks before the decision day. Some even said the market had priced in a rate cut already.

That suggests that rather than the central bank sending a signal to the market, the market (or the pundits) is giving orders to the bank.

The decision seems to have stopped the slide in the Canadian dollar, which is probably a good thing since most people thought it had dropped a little too far a little too fast.

If it stays where it is, our domestic manufacturers will be better off, and our exporters will still be able to cope.

Consumers of imports, snowbirds and other Canadian tourists won’t be happy, but hey, we’re going to have “sunny ways” to soak up here in Canada under Justin’s benevolent rule. We’re also going to have higher inflation than the government is predicting.

Food prices went up by more than four per cent last year and are going to go up by even more this year. The prices of restaurant meals (at both fast-food chains and regular restaurants) have also increased by more than 10 per cent over the last two or three years.

Property taxes are on the rise everywhere, partly to upgrade aging infrastructure, partly because governments like to raise taxes.

Electricity rates are also going up, especially in provinces like Ontario, where it is supplied by a government monopoly – ditto for water and sewer rates.

Yes, we have had some relief from lower gas and oil prices, but I don’t believe it has been enough to offset the increases in other areas.

In short, I no longer trust government numbers, and that lack of trust will affect my investment decisions.

I’m not sure I believe industry forecasts either. They either paint a rosy picture to encourage investment or sales, or they paint a bleak picture to solicit government handouts. As I indicated earlier in this piece, I expect both the economy and the financial market to be stagnant this year.

The Canadian dollar has probably bottomed out, but I don’t see it recovering much. Stock prices may still have another 10 per cent or 15 per cent to fall.

As corporate profits start to slip, some companies may decide to reduce dividends. This in turn will put more downward pressure on share prices.

Write covered call options

Just about the only way I can see for the ordinary retail investor to make any money from stocks this year (other than from dividends) is to write covered call options.

If the market remains stagnant, they will expire worthless and the writer gets to keep whatever he or she received for them.

If, by some miracle, the market recovers, the investor still gets paid the strike price, and has cash available to invest in something else.

If you’re trying to decide which shares to write options on, I would suggest you start by looking at bank stocks. Banks are probably the only industry sector whose share prices have held up (more or less) over the past year.

In my opinion, they are somewhat overpriced and hence, a good candidate for call options.

Any of the big five Canadian banks: Bank of Montreal (TSX─BMO), Bank of Nova Scotia (TSX─BNS), Canadian Imperial Bank of Commerce (TSX─CM), Royal Bank of Canada (TSX─RY), or Toronto-Dominion Bank (TSX─TD) are worthy selections, if you hold them in your portfolio.

Let me stress here that I am only advocating writing covered options – not naked ones. The latter are way too scary for me.

Covered calls make sense if you expect the market to be stagnant or to decline somewhat but still want to hold on to the shares. As long as any eventual market recovery comes after the expiry date, you get the extra income from the options.

Of course, there is always the risk that it will come sooner and you wind up selling at a less attractive price, but that is merely opportunity cost. You are actually no worse off than if you sold them today.

The big five banks are also good candidates for this because, despite their nice dividend yields and good price-to-earnings ratios, I’m not sure the spread between what they get from borrowers and what they pay depositors is all that good.

The Bank of Canada has recently mused about the possibility of negative interest rates. While Japan and some smaller European countries have already moved to this, Japan is a basket case, and has been for some time.

If Canada were to adopt such a position, it would be a disaster for the economy as a whole and the banks in particular. I suspect that the Bank of Canada actually already knows this, and won’t go that far, but the mere fact that the idea was even mentioned still frightens me.

If any major countries move to negative interest rates, the world economy will not merely stagnate, it will crash.

All the ordinary investor can do in such a case may be to dig up his or her back yard and plant potatoes, since most financial holdings will crash and burn.

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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