Richard Croft, president and chief investment officer at R.N. Croft Financial Group
Focus: Options and ETFs

MARKET OUTLOOK

Investopedia defines a melt up as a “dramatic and unexpected improvement in the investment performance of an asset class, driven partly by a stampede of investors who don't want to miss out on its rise, rather than by fundamental improvements in the economy.”

Could we be witnessing an equity market melt up? Maybe so, considering four factors:

1. The collapse of medium- to long-term U.S. bond yields.
2. A dovish policy shift at the U.S. Federal Reserve.
3. A potential easing of trade tensions after Chinese President Xi Jinping and Donald Trump’s meeting at the G20.
4. The presumptive ratification of the new NAFTA.

A lot must happen for stocks to melt up. It would be a quick rally, with algorithmic trading kick-starting equity markets. If my assumptions are correct, retail traders would come into the market as they often do at the end of a cycle. That would push prices higher, which is where we get concerned. The fallout from that type of melt up would be rapid and severe.

The challenge with any market move is the speed at which it takes place. That limits the ability to take defensive action after the fact. It’s better to position your portfolio ahead of time to limit risk should we experience a significant correction.

TOP PICKS

ALIBABA (BABA.N)
Recently purchased at $175.

Alibaba will be an indirect beneficiary of any trade agreement with China. This is not directly due to a lifting of trade restrictions, but because it should improve Chinese growth prospects, which will benefit online retailers. 

WELLS FARGO (WFC.N)
Recently purchased at $47.

Wells Fargo still faces challenges related to its previous scandals, but it has an excellent capital position and it’s not as sensitive to the interest rate spread as some of the other major U.S. financial institutions. More importantly, after passing the most recent stress test, management announced an 11-per-cent stock buyback (US$22 billion).We also anticipate a 10-per-cent increase in the quarterly dividend.

At current prices, Wells Fargo has a 4-per-cent dividend yield and an 11-per-cent buyback yield. That provides a solid floor below the bank, should the equity markets hit rough patch after a melt up.

SPDR S&P 500 MARCH 300 CALLS (SPY200320C300)
Recently purchased at $12.

This is a short-term aggressive trade for investors who buy into the melt up thesis, which should develop over the summer and be in rally mode by the fall. The call option limits risk should the markets stumble. The most you can lose is the cost of the call option, but you could lose the entire amount. Use only capital earmarked for speculative investments and exit half the position should the call trade at any point above US$20 per share.

The call option grants the holder the right to buy 100 shares of the S&P 500 Depositary Receipts (symbol SPY) at US$300 per share. The call option is quoted as a per share price, so each contract is valued at 100 times the per share price. SPY trades at one-tenth the value of the S&P 500 Composite Index, so the US$300 per share price equates to the 3,000 level on the S&P.

PAST PICKS: JULY 3, 2018

BMO EQUAL WEIGHTED BANK ETF (ZEB.TO)

• Then: $29.04
• Now: $28.75
• Return: -1%
• Total return: 2%

O'SHARES FTSE RUSSELL 2000 SMALL CAP QUALITY DIVIDEND (OUSM.N)

• Then: $27.24
• Now: $27.61
• Return: 1%
• Total return: 4%

FIRST TRUST DOW JONES INTERNET ETF (FDN)

• Then: $138.16
• Now: $147.43
• Return: 7%
• Total return: 7%

Total return average: 4%

WEBSITE: croftgroup.com
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