We are about to see just how in love investors have become with their stocks over the past 20 years.
The onset of earnings season, coupled with the looming reality that the Federal Reserve will raise interest rates from historically low levels, means that many stocks that have done well for a long time could struggle under the new realities.
To help handle whatever comes next, investors can think about using a simple options trading strategy to offset potentially stalled or sputtering stock prices that performed well in the past but might not thrive in the new market environment.
The strategy is simple. Sell calls that expire in a month or less, with strike prices about 10% to 15% above the stock price. If the stock price remains below the strike price, investors can keep the options premium.
This covered-call strategy pays people to be long-term investors—with one key twist: If the stock price is above the strike price at expiration, investors must sell the stock, or buy the call back at a loss, or roll to another monthly expiration date.
At this moment, nothing yet needs to be done, but investors need to start thinking of new ways of handling their old stocks as the market mob braces itself for higher interest rates.
We continue to believe that it makes sense to wait for the Fed to conclude its two-day meeting on Jan. 26. The meeting should introduce critical information, or confirmation of expectations, into the market.
In anticipation, investors are rerating stocks that have price/earnings multiples higher than the S&P 500 index.
These so-called growth stocks are often under pressure, or declining, while cheaper value stocks strengthen and advance.
So far, the rotations seem to be largely attributable to institutional investors who reason that the discounted cash-flow models used to value stocks mean that highflying technology stocks are suddenly worth less.
In essence, the future value of cash flows is worth less if rates are higher. Almost no one outside of the securities industry thinks or talks about discounted cash-flow models, which probably means that there will be hard lessons for people to learn after decades of seeing stocks reliably go up.
Mini-crises are likely to erupt in millions of portfolios as investors confront the end of historically low interest rates that have long kept stock prices aloft.
Many stocks—especially highflying technology stocks that have long led the broad market ever higher—may no longer behave like they have in the past. Investors will probably be loath to sell stocks that have performed so well, even if they manage to deploy money into the new hot sectors, including financials and cyclicals.
There’s no doubt the stock market is in flux. Investors are debating what may happen once the Fed raises rates or provides greater clarity. Rather than guessing what will happen, develop a plan and be ready to react to concrete news rather than just speculation about the future.
Some investors won’t want to pay taxes on unrealized gains. Others will contend that the broad market, and their favorite stocks, will soon stabilize once monetary policy normalizes.
Everyone could be partially right and wrong, and there is little to be gained by trying to guess the outcome. Instead, if you have stocks that might get banged around, or that have sputtered in recent weeks, consider using the covered-call strategy.