Nov 9, 2018

Richard Croft's Top Picks: Nov. 9, 2018

BNN Bloomberg

Richard Croft , BNN Bloomberg

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

MARKET OUTLOOK

There was “insightful” spin on financial networks advancing reasonable cause-and-effect explanations for the Oct. 10 sell-off. But more than any single motivating factor, it was about AI. What makes me believe this was based on an algorithm was the fact that despite the sell-off occurring all across the board, we didn’t see significant capital movement away from stocks as an asset class into bonds and gold.

AI has shortened the timeline of seismic shifts in the market. What use to take weeks as traders transitioned from bullish to bearish now happens in days or even hours.

I’m not a big fan of money management via algorithms; it’s not new and previous iterations haven’t benefited investors. For example, the 1987 stock market crash was exacerbated by programmed trading where algorithms systematically raised cash when specific price points were breached. As the market fell through predetermined levels selling picked up, causing further downside movement. The speed of the October 1987 sell-off caused widespread panic and in the end didn’t protect investors in the way it was originally intended. Programmed trading went down as a failure and was pushed to the sidelines through much of the ‘90s.

But in Wall Street, what comes around goes around and as a result, algorithms now account for as much as 30 per cent of the trading activity on any given day. This at a time when there are fewer shares to trade because of significant stock buybacks and institutional investors who follow a buy-and-hold approach (think Warren Buffett).

Make no mistake: NYSE and NASDAQ market makers, who are charged with providing liquidity, are keenly aware when they’re taking the other side of a trade triggered by an algorithm. They also know that a machine is acting on electronic impulses and they will take advantage of that by shifting the bid and asked prices in accordance with the direction being taken by the algorithm. For the rest of us, that creates a trading pattern where we get sporadic volatility spikes interspersed with longer periods of narrow price swings.

It’s virtually impossible to trade within these variables. I only hope that understanding what’s happening behind the scenes provides some comfort that will allow you to stick with an investment plan through turbulent times.

If you believe as I do that intraday gyrations are more noise than substance, you can focus on the factors that have real long-term implications. If institutional investors are shifting strategies from momentum to value, banks should benefit and FAANG stocks should weaken. Same with the interest rate scenario: Higher rates should benefit banks, insurance companies and large-cap tech companies with sizable cash hordes. Higher rates will be detrimental to small-cap stocks because borrowing costs will rise and will be particularly harmful to companies with significant leverage. I’m not sure that the current rate environment will have any major repercussions, but clearly the 3.25 per cent rate on U.S. 10-year Treasury notes is the current demarcation line.

But here’s the rub: Suppose we’re correct about what’s driving investment decisions. The point of our AI preamble is that much of what we think will happen has probably been priced into the market. The reaction time is simply too short to make moves after the fact, which means it is better to hedge your risks with a portfolio that can function within a multitude of detrimental scenarios.

For example, given the current macroeconomic overlay, think about a portfolio that has some high-quality Canadian banks that pay above market dividends. Perhaps hold some momentum stocks via a technology ETF like the Invesco NASDAQ Internet ETF (PNQI) which has about 40 per cent of its assets invested in the FAANG stocks. Add some value stocks with the iShares Russell 1000 Value ETF (IWD). IWD seeks to track the investment returns results of an index composed of large and mid-capitalization U.S. equities that exhibit value characteristics.

Bottom line: build an all-weather portfolio within your risk profile. Trying to trade the current environment will harm your pocketbook.

TOP PICKS

APPLE (AAPL.O)
Synthetic long stock
BUY: AAPL Jan. 2020 215 calls at US$24.
SELL: AAPL Jan. 2020 215 puts at (US$24.60).
Net per share out-of-pocket cost: -US$0.60.

A long call and short put on the same underlying security with the same expiration dates in considered a synthetic long stock position. The long call/short put should track the up and down movements in the underlying shares virtually dollar for dollar. Because this is a synthetic trade, you can execute the position with no out of pocket cost. However, you will have to post margin to cover the obligation of the short put (the obligation to buy Apple shares at US$215). Ideally, you want the market to begin valuing Apple as a service company, which is becoming more significant in terms of the company’s revenues. As a service company, the market should give it a higher multiple than it currently has as a hardware manufacturer.

MSCI CHINA LARGE CAP ETF (FXI)
BUY: FXI at US$41.35.

BOEING (BA.N)
Covered call
BUY: BA at US$369.
SELL: BA June (2019) 370 calls at (US$31).
Net per share out-of-pocket cost: US$338.

Potential outcomes over eight-month holding period:

BA rises: Call exercised stock sold at US$370. Return: 9.47 per cent.
BA unchanged: Call expires. Investor retains stock. Return: 9.17 per cent.
BA declines: Downside-protected to US$338. Return: -8.40 per cent.

The theme underpinning picks two and three, is premised on the view that trade tensions will mitigate into 2019. Trump and Xi are meeting at the G20 in Argentina and I suspect cooler heads will prevail and some groundwork will be laid for a negotiated agreement. Neither side will get everything they want, but it will ease tensions between the two largest economies. If this occurs, China’s large-cap stocks should respond positively which will benefit FXI. Boeing should move higher, although with their current backlog much of the good news may be priced into the stock, hence the reason for the covered call.

PAST PICKS: DEC. 18, 2017

RUSSELL 200 INDEX (IWM) March 150 calls