A little gold, short financials, and prepare for inflation

I haven’t blogged lately as I haven’t had any good ideas, maintain my same investment thesis, and am lazy. The only thing I’ve added is a gold trust etf. It has moved up nicely. All it does is own gold bars-a pure play on price appreciation.Inflation is coming and this is a diversification to some inflation oriented bond plays.

I haven’t added to any long positions in equities as I think we will go lower in spite of the Fed and the stimulus.

That’s all folks.

Get ready for stagflation

If I was 100% confident in my abilities to see the future my preparation would be better. I’ve been preaching economic slowdown for months and also worried about rising commodity prices causing ripples in the industrial sector. But trends never develop as quick as I become alarmed. So I’ve stayed invested in stocks defensively while moving a decent amount of capital to short term governments, money markets, puts, and wrote covered calls on many stocks.

The “market” is concentrating on whether the Fed is doing a good job of avoiding recession and hasn’t seriously focused on inflation. It’s only a matter of time before inflation becomes the second reason why stock prices will be under pressure.

Lots of investors flee to bond funds during stock downturns. Avoid all but the shortest types. AVanguard short term treasury fund has returned me 7 1/2% over the last 6 months as investors fled stocks and rates fell. That type of fund will likely continue to do fine as the Fed lowers short rates. But watch out for all other types of bonds as inflation and a slowing economy scare overseas buyers. They will demand greater yield to stay invested and bond prices will decline. Inflation is about to make the Fed’s mission very difficult.

So what am I doing to deflect the effects of inflation? A little gold, a little bet on a strengthening dollar as rates rise, and an inverse long term bond fund that increases in value as rates go up whereas a normal bond fund goes down as rates rise. This is kind of squirrely since it uses derivatives and I have not been kind to people that buy products they don’t understand and I haven’t investigated all of the counterparties involved. But we’re not talking about a large sum of money so i view it as an experiment.

I’ve also lowered my expectations for 2008 to maintaining capital. If I’m worth the same at the end of December 2008 as I had at the end of 2007, the year will be successful. Given the state of stocks and bonds, the huge runs already in commodities and emerging markets, and the weaknesses in the credit markets, we’re going to have a very challenging twelve months. Heres to breaking even.

Preserving capital will soon direct investment decisions

After today’s market action, the Dow and the S&P are back to 12/06 levels and th NASDAQ is only slightly above its ’06 level. Investors have finally started to come to grips with the strong possibility of a recession and ratcheted stocks down violently the past few days. Markets don’t move in a straight line so there is time to lighten up positions at better prices when we see a bounce back. But I suggest becoming defensive if you already aren’t.

The earnings yield is the reciprocol of the P/E. If you divide the eps by the share price you get a stock’s earnings yield. A 20 P/E is a 5% earnings yield. If that yield is higher than say the 10 year treasury, you are getting paid to take the additional risk of investing in the stock vs. the safety of the bond. We’ve been in that situation for quite awhile. It’s about to change.

Inflation is here and just as investors finally acknowledged the possibility of a recession, they will soon acknowledge the fact that “core inflation” is an academic exercize and real inflation has been building at a rapid pace. Inflation will cause higher bond rates making the earniings yield unattractive which will result in P/E’s lowering.

Additionally, treasuries have been a safty haven, but that may change as the U.S. economy enters recession. If inflation and recession coincide we could see a strong downward move as bond rates dictate even higher stock earnings yields. That means lower P/E’s leading to lower stock prices.

All sectors will not be treated equally, so pick your stocks carefully.

Wringing more income out of a portfolio

It’s cold today in Florida, almost as cold as today’s market action. In fact, it’s so chilly that my wife drove the car to our mailbox to pick up the mail! I decided to stay inside and blog about how a person can wring some income out of stocks that you aren’t ready to sell.

As the faithful reader will remember, I have been pessimistic about the market’s potential for the last 90 days and have lightened my equity risk substantially by selling positions, buying puts, and building a bond ladder. But I still have a portfolio of stocks that are defensive in nature and, hopefully, won’t be decimated as badly as the general market may be this year.

To maximize my return, or minimize my loss, on this portfolio I look to their dividends plus any revenue that I can garner from writing covered calls. Almost all pay dividends of between 1% and 2% and I can earn a like amount annually writing calls. Thus, most likely, I can earn 2% and 4% which either gives me a headstart on a good year or reduces my brusing if the year is a bad one.

I only write covered calls on stocks that I already own and like. I generally don’t buy a stock just to write the call. I never write a naked call where I don’t own the stock. Also, I only write them on positions that I don’t mind having them called away from me-so I have to be ready to pay the capital gains tax.

A quick example if anyone is interested. A stock sells for 70. You agree to sell it for 75 anytime up till February 20 in return for a premium of $1. So, if you would be content to sell at $76 within the next 2 months you can’t lose. Assuming premiums stayed about the same, you could do the same thing several times during the year which, in addition to the dividend, puts a nice floor under the stock’s performance.