THE UNSUSTAINABLE RALLY-NOW WHAT? COMMODITIES FOR INCOME INVESTORS

1. Introduction

What does the past week’s market activity tell the high dividend income investor who is considering taking new long positions to get some return on cash that’s lying fallow? What follows is nothing fancy, people. Just a simple follow up and update to last week’s post Notes on a Scandal: High Dividend Investor's Survival Guide to This Unsustainable Rally, and some practical tips on what to do now.

Caveat: I’m not a prophet. The following conclusions are just based on the evidence I present below that this is not the time for new long positions. I’m still innocently (naively?) assuming we have a free, open and transparent market operating. However, given the degree of market manipulation we’ve seen (see Notes on a Scandal: High Dividend Investor's Survival Guide to This Unsustainable Rally) and mentioned in recent posts, one could argue otherwise and try to bet on a continuing rally aided and abetted, legally or not, by team Washington & Wall Street.

2. What The Charts Suggest

A. Chart 1

Overall market broke its long term downtrend at the end of March, and the rally has stalled out in early May.

B. Chart 2

For the past 6 months the market has traded in a range between 680 and 940.

C. Chart 3

Since the rally stalled in early May, volume on down days is greater than that on up days, and there have been about 3 times more down days than up days. This suggests lack of conviction by market participants.

3. Conclusions

A. Be Cautious Taking New Long Positions

From a very simple technical perspective, the current rally has stalled. From a fundamental perspective, as noted in Notes on a Scandal: High Dividend Investor's Survival Guide to This Unsustainable Rally, the rally is mostly unjustifiable, and arguably the result of outright manipulation by Washington and Wall Street. Perhaps this is for the greater good. It has allowed at least some of the major banks a rising market into which they can sell stock and raise needed capital from willing investors, not just captive taxpayers. For example, both Goldman Sacks and Bank of America have done so thus far.

B. What This means for Dividend Income Investors

Yes, it hurts to sit with cash producing no income. Because both fundamental and technical evidence suggests it’s more likely that stock prices in the coming months will fall, recent advice still holds. Take only partial positions using cash that will not be needed within the foreseeable future. Consider taking at least partial profits or losses if you foresee needing to raise cash in the coming months from your stock portfolio. Consider hedging techniques discussed in prior articles.

For example, for short term hedges consider: UltraShort S & P 500 Proshares (SDS), UltraShort Financials ProShares (SKF), UltraShort QQQ ProShares (QID), UltraShort Real Estate ProShares (SRS), UltraShort Russell2000 ProShares (TWM).

For those who can, consider owning Canadian or Australian dollars, or assets based in these currencies. Why? To alter the famous line about plastics from the film, The Graduate, “commodities, Benjamin, commodities.”

C. The Real Meaning of What Jim Rogers Has Been Saying

This past week renowned investor Jim Rodgers was widely reported to predict a coming crisis in the currency markets as governments worldwide attempt to bolster their economies by expanding the supply of their currencies, thus ultimately eroding their purchasing power once the world economic situation improves and demand for goods rises.

Even for those well versed in currency trading, that advice is not easy to put into practical use. If all currencies are inflating, and currencies always trade relative to one another, so how does one know which currency to prefer over another?

One could consider which currency is being most burdened with debt and thus likely expansion of supply, as suggested by the following IMF (International Monetary Fund) chart provided by Kathy Lien in Will the U.S. Be Next to Receive a Credit Warning?

That might work if you want to trade currencies AND the rest of the market follows the same chart. Maybe it will work, maybe it won’t. Successful trading is not just about being right about the asset, but being right about what the rest of the market will think about it, and when.

Here’s simpler idea. While choosing the right currency pair may be unclear from Rogers’ remarks, what IS clear is this: commodity prices should be in a long term uptrend, if for no other reason than their being priced in eroding currency, typically US dollars. So invest in instruments that will rise with commodity prices.

THAT is the obvious implication from Rogers (who has made a few bucks in commodities).

Thus consider, strongly, one or more of the following investing options:

· Commodities themselves via ETFs, CFDs, futures, etc. A very creative and worthwhile suggestion from a comment I received on an article, one which I recently followed – consider a investing in a hybrid car, better home insulation, or other energy saving devices. Yes, cars are depreciating assets, but if you have to commute long distances anyway, the savings could well be worthwhile. FYI I went for a Toyota (TOY) Prius. It handles very well, has sufficient acceleration when needed, and cut my gas bill by more than half. My only complaint is the very primitive sound system, especially considering this is not a cheap car. It’s not strictly an income investment, but a penny saved IS a penny earned. No, it’s better. There is no tax on the penny saved (yet), at least until you invest it.

· Convert at least some US dollars to Canadian or Australian dollars (which rise relative to other currencies as commodity prices rise)

· Income instruments based on commodities that should rise with them. Many of the stocks I’ve been recommending fit that description, especially WHEN stock prices pull back. These include:

· Big Oils: BP, plc (BP), CNOOC Ltd. (CEO), Enid SpA (E), Total Fina Elf (TOT)

· Canadian Energy Trusts: ARC Energy Trust (OTC: AETUF, TSX: AET-UN), Claymore/SWM Canadian Energy Income Fund (ENY), Enerplus Resources Fund (ERF), Peyto Energy Trust (OTC: PEYUF, TSX: PEY.UN), Provident Energy Trust (PVX, TSX: PVE.UN), Vermillion Energy Trust (OTC: VETMF, TSX: VET.UN)

· Coal MLPs: Alliance Resource Partners (ARLP), Northern Resource Partners (NRP), Penn Virginia Resources Partners (PVR)

· Canadian Real Estate Trusts: While real estate is not a commodity, it is a hard asset that is inflation resistant. A worthy group of stocks to keep in mind when prices pull in include the Canadian Real Estate Trusts: Canadian Apartment Properties REIT (OTC: CDPYF, TSX: CAR.UN), Northern Property REIT (OTC: NPRUF, TSX: NPR.UN), RIOCAN REIT: (OTC: RIOCF, TSX: REI.UN

The Gabelli Global Gold, Natural Resources & Income Trust (GGN): a way to play gold and get income

However, again, be cautious about new stock purchases until we see a pullback. Why? Here’s a lesson worth repeating.

D. Even Great Stocks Usually Follow The Market

Remember, no matter how good their results, few stocks avoid selloffs when markets decline. So be cautious buying income stocks based in commodities or commodity based currencies at this time.

For example, look at a chart of Atlantic Power Corporation (OTC: ATPWF.PK, TSX: ATP.UN) compared to the S&P 500 (in red).

Note that ATPWF’s price movement followed that of the S&P 500 index. Despite producing stellar results during this period, including raising dividends while cutting debt and openly declaring the dividend secure for years to come; its price fluctuated in the same directions as the index.

Ironically, ATPWF’s price was actually more volatile (due to its low daily trading volume), despite its far healthier and more stable revenue stream than almost all companies in the index.

The lesson: you generally do not take long positions when the evidence suggests prices will drop. thus even though the recovery of energy prices and stocks seems inevitable, it’s not yet the time to buy. By all means place orders starting near the March lows, though.

4. Conclusion, Disclosure & More Info

Again, the Caveat: I’m not a prophet. The following conclusions are just based on the evidence I present below. I’m still innocently (naively?) assuming we have a free, open and transparent market operating. However, given the degree of market manipulation, (see Notes on a Scandal: High Dividend Investor's Survival Guide to This Unsustainable Rally) mentioned in recent posts, one could argue otherwise and try to bet on a continuing rally aided and abetted, legally or not, by team Washington & Wall Street.

Disclosure: I have positions in most of the above mentioned investments.

Interested in learning more about investing in stocks that provide reliable high dividends with better transparency, appreciation potential, and liquidity than bonds? Visit http://highdividendstocksguide.blogspot.com

THE UNSUSTAINABLE RALLY: A HIGH DIVIDEND INVESTOR'S SURVIVAL GUIDE

 

This may be a tradable rally, but non-traders should stay away, this is no time to be buying new long positions for a long term hold. Why?

1. Notes on a Scandal: A Brief Chronology of the Latest Rally

For those lacking the time or technical background to follow some of the superb Seeking Alpha contributions on the dubious origins and nature of the current rally, here's a simple summary and explanation how the current rally developed. I omit much technical detail and encourage readers to look at the articles referenced below.

Surprise bank profits spark optimism. In early March, the Major Banks surprised the markets by actually showing profits. Because rapidly growing losses from subprime loans in the financial sector and an ensuing lack of affordable credit were the immediate cause of the bear market, this very positive surprise sparked a rally. It appeared that the root problem was being resolved.

PPIP adds fuel. As the rally was stalling out at resistance (around 800 on the S&P index) when on March 23 the government announced its Public-Private Investment Program (PPIP), which gave the rally an additional push over that level.

Rising stock prices set off short covering. This rise set off computer programmed purchases of shorted stocks to close these positions at predefined prices to limit risk of loss by quant funds. These are investment funds that trade based on quantitative models, a fancy term for computer programs that automatically trade based on sophisticated and complex mathematical formulas or algorithms. While this "short squeeze" buying by short sellers to limit their losses is a normal part of a rally, it is usually a short term reaction to limit risk, not a genuine basis for a sustained rally.

These purchases fueled a continued rally on unconvincingly low volume until about May 11^th. Sustainable rallies tend to show above average volume on up days, and lower volume on down days.

Since May 11, the markets have been dropped back and are trading in a tight range.

2. Argument Against the Rally

Again, here is a very basic summary of why going long is especially dangerous for anyone but those seeking a quick trade while the rally lasts.

A. The major banks are neither profitable nor healthy

As was first publicized by fellow SA contributor Tyler Durden then further discussed by others, these results were essentially falsified by a combination of

Manufactured one time profits: Manipulated trades using taxpayer funds funneled through AIG that produced fixed income department trading profits large enough to outweigh the losses in every other area of operations, thus producing an overall profit

Government regulators allowed assets to be misleadingly overvalued and / or classified as less risky. The ultimate example of official collaboration in this charade was suspension of mark-to-market accounting, a rule which required the banks to value their assets (outstanding loans in particular) at actual market prices as determined by the most recent sale of similar assets, just like on the stock market. Now the banks were allowed to value these assets at or near full value as long as the loans kept up their payments. How surreal is this? For example, as of this writing GM bonds have not missed a payment and therefore could be valued at or near par value. In fact, these bonds sell for about 8% of par, reflecting the market's justifiable concern that GM will soon be unable to make payments. It's like saying a terminally ill patient is healthy as long as he's breathing.

B. Low trading volume shows few believers

The rally was stalling out at resistance (around 800 on the S&P index) when on March 23 the government announced its Public-Private Investment Program (PPIP), which gave the rally an additional push over that level. The continued rise, however, was on low volume which suggests a lack of popular belief in the rally.

C. Insider selling

According to the Washington Service, in April NYSE listed company insiders have been selling into this rally at the fastest rate since October 2007. As pointed out in and earlier SA article, Why This Rally Is Unsustainable,

"To give that some context, the S&P topped out on October 11, 2007 and declined 57% before hitting March 2009 lows."

In other words, those most knowledgeable about their company's prospects are not buying the stock.

D. Further residential mortgage defaults coming

As James Quinn pointed out in Suburban Housing Markets are Unsustainable Part 2, the financial sector is facing a further wave of residential mortgage defaults, because the decline in home values and the value of the mortgages on them is far from over.

· There is an all-time high 13 months supply of new homes, and a 10 month supply of existing homes for sale.

· There will be an estimated 2.1 million foreclosures in 2009 versus 1.7 million in 2008, and 7 to 8 million more people will lose their jobs in 2009

· In 2010 and 2011 the payments on millions of adjustable rate mortgages (ARMs) will reset, often at 50% higher or more. Most of these homes are already worth less than the debt on them, and thus millions of new foreclosures are coming as homeowners walk away and leave the banks with even more bad debt.

E. Commercial mortgage defaults growing

As highlighted by the bankruptcy of General Growth Properties, formerly the largest mall operator, commercial real estate debt. As I noted recently in Must-Know Info for Investing in Commercial REITS, If You Dare:

There’s plenty of potential for more trouble with the commercial REITs. Per Deutsche Bank, two thirds of about $154 billion of securitized commercial mortgages coming due between now and 2012 will not qualify for refinancing due to the 35% - 45% decline in property values since their 2007 peak. This estimate could get far uglier if even about 10% of mall properties need to be sold off. There are relatively few buyers for such big ticket properties. Thus commercial property values would drop further, thus lowering the value of the surviving commercial REITs and making financing harder still.

F. Credit card losses-another ticking bomb

Worst case bank stress tests estimated that America's 19 biggest banks could lose nearly $82.4 billion in credit card losses by the end of 2010. This is likely to be an underestimate because:

If unemployment exceeds 10%, which many economists predict and may already have occurred (depends who you listen to), these losses could go far higher.

G. Bank stress tests ignore much of the coming credit card defaults

Worse still, the bank stress tests published losses only for credit cards held on bank balance sheets. They ignored tens of billions in losses tied to credit card loans that was packaged into bonds and held OFF the banks' balance sheets.

3. ARGUMENT FOR THE RALLY

· There is over $ 5 trillion languishing in money market funds earning nothing, and at least some of it is waiting to buy on a dip.

· There have been nine bear rallies since 1970. The average length is four months. So far, this rally has lasted just over two months.

So maybe the rally will go on for a few months more? So what? The key point is this rally doomed and thus strictly for traders or those seeking to take some kind of short position as a hedge for when the decline resumes. Buy and hold income investors should generally avoid taking long positions until prices either retest March lows or the there are genuine improvements in underlying fundamentals

4. WHAT TO ACTUALLY DO

OK, so what do we actually do? Here are some ideas.

A. Steps to protect profits or limit losses

1. Place stop loss orders

Use stop orders on positions for which you want to protect profits and would be willing to try waiting to repurchase at a lower price, either using a fixed price level or a trailing stop to protect profits. Ideally, these should ALWAYS be set soon after you buy the stock, so that the sale is automatic when the stop loss is hit or exceeded, thus removing emotion the sell decision.

How important is this simple risk management? In the words of Bernard Baruch:

If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.

2. Sell Covered Calls

Sell covered calls to partially protect profits – an alternative to selling outright shares that you really don't want to sell or have bought at much lower price so you can lock in some of that profit plus gain the cash from sale of the covered call. If prices fail to breach your strike price, you can continue to sell calls and milk the shares for additional income if the lower strike price still leaves you with a profit making the sale worthwhile. For those unfamiliar with selling covered calls, see 3 Must-Know Options Strategies for Dividend Investors.

3. Sell your stocks short

This is strictly for those who want to trade and have the time and expertise to watch these carefully. Higher reward, but higher risk and more time needed to watch these. Of course, place stop losses on these as well – always.

B. Prepare to buy at conservatively low prices

When the next move down shows signs of stabilizing, that will be the time to buy income stocks with cash you can afford to let sit in case of further declines. Remember, cash earns nothing, so and inflation will erode it badly, so at least some of your investing capital should be deployed when fear is high and the market is bottoming. I know, easier said than done, but that is the goal.

Sell puts (right to sell to you) at or near a support price. While can be done in advance, you get the highest price when the stock price has already come down near the strike price you want (price at which you've sold the right to sell to you). Even if price doesn't fall that far, you still get paid. This beats just sitting with cash that gets nothing while you wait for orders that may or may not get hit.

Set buy orders at likely support to take partial positions. Put options aren't always available (especially on more thinly traded foreign shares) or not available at a strike price you want. A bit above the March lows would be a conservative starting point to take partial positions.

C. Hedge your overall portfolio

If you don't want to bother shorting each individual position or selling covered calls on each stock you own, do so on stock indexes that resemble your portfolio or parts of it. That is, protect your long positions by taking positions that profit when the market or stock drops. The usual methods of shorting individual stocks or indexes include:

1. Sell covered calls on stock index ETFs you own at strike prices above your cost to lock in profits.

You get the highest premiums for these when the market is rallying and there are investors anticipating higher prices, while the rally limps along this is an ideal time to sell covered calls. If the stock is below the strike price on the expiration date, you just keep the cash and can repeat the process, possibly milking the same shares for repeated covered call shares sale revenues. If the market price is above your strike price, your buyer will exercise the right to buy at that lower strike price. Perhaps you miss some profits from possible additional appreciation above the call price, but you lock in the rest. Good for when you already have profit at the strike price. Also can be a great way to milk a stock for extra income if you're good at calling near term price tops and then selling the calls (which sell for more when the stock is high and buyers anticipate additional price increases).

2. Sell Contracts For Difference (CFDs) on a stock index that best resembles your long position.

This will be a new idea for many of you.

What are CFDs? As the name suggests, CFDs are based on the change in prices of futures contracts, just like a futures contract or option is a bet on the price movement of a commodity, index, or stock.

For example, to hedge a portfolio of US stocks, sell a CFD on the S&P 500. You profit as the S&P declines. While not mentioned much in the mass media in the US, they're well known outside North America. Essentially they are bets on the direction of futures contracts on various instruments like commodities or stock indices. Like any derivative product, you MUST do your homework to understand the pros and cons. Used correctly, CFDs can be cheaper than buying puts and better suited for long term hedges than ultrashort ETFs.

One of their key benefits and risks with these is that the online brokers grant very large leverage on these. The upside is that you can take positions with little capital, and can make very large gains when you're right. The downside is that you can lose money quickly if you don't manage your risk carefully with stop losses, which you should ALWAYS use with these.

The best free educational sources on CFDs are on some of the various online forex and commodity brokers and market makers at their web sites. A Google search using terms like "online fx trading platform" will give you a list of sites to consider. Some criteria to evaluate them include:

· No commissions or fees

· Great educational resources

· A wide variety of CFDs

· Telephone and live chat support

For example, I found a good introduction at AVA FX (avafx.com) under the CFD tab. They provide free telephone and live messaging support in a variety of languages, if you have questions, and offer CFDs on a large variety of stock indexes and commodities, so you have lots of options for diversification. They are market makers, not brokers, so there is NO commission or fees. There are many others as well, but I've worked with AVA and had no problems. If you look for reviews of various online forex and commodity sites, there are lots of complaints about most of the sites out there. I don't know if these are justified or not, but clearly you need to do your homework about which are legitimate, and ideally get some personal references.

Here's a sample table of offerings.

Sample Table of Contracts For Difference (Courtesy of AVA FX)

3. Buy ultrashort ETFs for a short term trade.

This option is only for the traders among you. As mentioned in earlier posts, these are easy ways to take short term short positions on various indexes or sectors. Again, these are for those with more risk tolerance. If you think you can catch the next leg down early, consider some of the Proshares ultrashorts like the SDS (rises at 2x the rate of decline of the S&P 500). Given the above mentioned issues regarding the financials and the sheer manipulation of their stock price rise, the SKF (like the SDS for the financial sector) could be rather lucrative.

WARNING ABOUT THE SKF: Of course, given the amount of, ahem, "purported" outright conspiracy between the banks and Washington, one could draw the opposite lesson and avoid shorting financials, fearing further likely bailout/rescue/trading suspension/ whatever.

I'm being perfectly serious. It's quite conceivable that shorting financials could again be banned, more one time profits manufactured, etc. Remember, when Wall Street and Washington band together, it's risky to get in their way. Who said life was fair?

5. CONCLUSION

Best Wishes,

Cliff Wachtel

http://Highdividendstocksguide.blogspot.com

Disclosure: The author positions in the above instruments.

CRITICAL INSIGHTS FROM FOREX TRADERS ABOUT THE U.S. STOCK RALLY

 

1. Forex Traders Provide Insights for US Stock Investors

Around $3 Trillion in foreign currency (forex) is traded every day, almost 10x the volume of US stocks. A lot of smart people trade forex. Every government, large financial institution, and business that buys or sells overseas trades forex to hedge their investments and production costs, as do hundreds of thousands of private professional speculators worldwide. Thus it's well worth heeding their opinion about the current rally.

A. Background: Different Currencies Have Different Risk/Reward Profiles

As a general rule, when US stock indices rise, the world currency markets feel more optimistic about the world economy, and show higher risk appetite. This in turn increases demand (at least in the short term) for currencies that carry higher risk of depreciating in bad times yet pay higher interest rates on deposits. When US stock indices are dropping, currency traders are often more pessimistic, and flee higher risk currencies into lower risk currencies.

Here's a brief quiz. Look at the table below showing central bank rates of the world's major currencies. Which do you think are considered the most risky? Which are considered the safest?

Approximate Central Bank Rates (fx360.com)

Answer: the Australian dollar is considered the riskiest. The Yen is considered the least risky, with the U.S. dollar considered the next safest. You may agree or disagree, but this IS the prevailing belief in the world currency markets.

B. Background: Currencies Trade in Pairs

Almost everything is priced in terms of a currency. So are currencies themselves. They are always traded in pairs. For example, what's the Euro worth? It depends on what currency you value it in. Here are a few examples.

Sample Euro Currency Pairs (Courtesy AVA FX)

In other words, the Euro as of this writing sells for 1.7677 Australian dollars, 1.5725 Canadian dollars, 1.5131 Swiss Francs, etc.

2. A Rising USD Suggests Forex Traders Doubt the US Stock Rally

If forex traders believe in a US stock rally, they feel more optimistic about the world economy. The Yen and USD tend to lose value in the short term against other major currencies as traders seek riskier currencies with higher yields. If they don't, the Yen and USD rise as traders seek safety over yield.

For reference, here's a daily chart of the S&P 500. Note how the recent rally began in early March (as positive news about US banks started to come out).

The S&P 500 (courtesy AVA FX)

C. AUD/USD Traders Doubt the US Stock Rally

Below is a daily AUD/USD (read: USD per AUD) chart.

Note that the currency pair AUD/USD is read as "USD per AUD," and NOT like a mathematical ratio of AUD per USD.

What do forex traders think about the US stock rally, based on this AUD/USD chart (i.e. USD per AUD)?

AUD/USD DAILY CHART (courtesy AVA FX)

Note that as the US stock rally proceeded, the AUD rose against the USD. Forex traders felt optimistic about the budding US stock rally as it rose off of oversold levels. Thus they were willing to accept the risk of holding the AUD for the sake of the higher yield.

Over the past few days, however, the rise has stalled along with the US stock rally.

The implication: the AUD/USD forex traders doubt the rally will continue. If they believed in it, they'd continue to flock to higher yielding currencies.

D. USD/JPY (Read Yen per Dollar) Traders Also Don't Believe in the US Stock Rally

The Yen is the only currency considered safer than the USD, and as shown above sports an even lower yield. If the rise in the USD was due to something other than risk aversion, we'd expect the USD to rise against the Yen. However, it has been falling for weeks against the only currency consider safer.

THE USD/JPY DAILY CHART (courtesy AVA FX)

Note how weeks before the current US stock rally stalled, the USD/JPY forex traders were betting against the rally and sought the perceived safety of the Yen, driving its value up against the USD.

Implication: USD/JPY traders are also feeling more risk averse because they don't believe the US stock rally will last.

3. CONCLUSION

Admittedly, forex is notoriously complex, and a variety of factors could influence the above charts. However the above charts reflect the overall recent strengthening of the USD against various other currencies. There are also those who believe that the dollar simply moves short term inversely with the US stock markets.

They key point – the forex markets are not showing belief in the US stock rally. Should we?

If not, get ready to take positions that benefit from a declining market. These include:

Using short term hedges like Proshares Ultrashorts ETFs like SDS (rises 2x the decline rate of the S&P) or SKF (same but for financials)

Selling covered calls on stocks you own for extra income. See 3 Must-Know Options Strategies for Dividend Investors -- Seeking Alpha for more info.

Want more ideas on how income and dividend investors can best survive and prosper on the next leg down? Stay tuned for the next article on this very topic.

NOTE: If Seeking Alpha readers cannot view the above charts, go to http://highdividendstocksguide.blogspot.com to view the blog in its original form, usually a day earlier.

Cliff Wachtel

Your Highdividendstocksguide Blogger

Disclosure: The author may own interests in the above traded instruments.

TWO MUST-HAVE CANADIAN INCOME TRUSTS FOR HIGH DIVIDEND DIVERSIFICATION:

 

Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), CML Healthcare Income Fund (TSX: CLC-U, OTC: CMLIF)

PART 11 OF A SERIES: THE HIGH DIVIDEND INVESTOR'S COLLAPSING DOLLAR SURVIVAL GUIDE

1. INTRODUCTION: A TELECOMMUNCATIONS AND HEALTHCARE SELECTION FOR DIVERSIFICATION

There aren't many stocks in the healthcare and communications sectors that offer dividends that are reliable, high, AND in a dollar hedge. So it's exciting when you find them, because they give you some diversification into these sectors.

The two sectors share similarities.

Due to steady demand in both sectors, well run firms in these fields can prosper even in bad times due to the steady demand.

The key phrase here is "well run." While there is demand, few firms in either field have greatly prospered.

Telecom firms have seen their traditional cash cow land line monopoly businesses eroded by cable, wireless and internet competition, and only those telecoms that could grow in these competitive areas have been able to prosper.

Health care firms typically must be very efficient at processing lots of paperwork correctly (or suffer payment delays) and coping with fixed reimbursement rates.

Note: As I hope to detail in another post, I am not a believer in this rally. Thus it's a treacherous time to take new stock positions, especially given the recent run up of these and other recommendations in this series. Do not buy above the limits stated below, and even then take only partial positions unless we revisit the March lows.

2. Bell Aliant Regional Communications Income Fund

Bell Aliant Regional Communications Income Fund (OTC: BLIAF, TSX: BA-U ). Given the dubious nature of the current rally and the very thin daily volume traded on this stock (and thus extra potential for volatility), buy only on dips below 19. Yield over 11%.

BLIAF had strong Q1 results. Like any telecom that is prospering in the era of increased competition to their landline businesses, they're growing income from Internet and other advanced services to more than compensate for the steady decline in revenues from traditional local and long distance landline phone operations.

Highlights include:

· Conservative Payout Ratio: Distributable cash flow again easily covered distributions with a payout ratio of 83 percent, despite a 13 percent increase in capital spending to upgrade the network for faster services.

· Tighter Business Focus, Improved Cash Position: The trust also completed the sale of its Defense oriented unit, focusing operations and boosting the balance sheet with proceeds of CAD16 million now, to be followed by CAD8.5 million later in the year.

· Cost Cutting: Resulting in rising margins during the quarter even as overall revenue slipped 1.2 percent. Internet revenue grew 10.8 percent on 8.6 percent customer growth and a 5.4 percent increase in revenue per user, as the trust’s data business continued to grow.

· No Debt Pressure: By nature telecoms need to make big capex investments and thus depend on a cooperative debt market. That's not the case now. Fortunately, the firm has no significant debt due until 2011, so they have time for things to improve.

In sum, this is sound business that’s prospering in the toughest market in generations. That's a reassuring sign that management is on top of its game and will continue to be able to exploit further opportunities in broadband and wireless services.

3. CML Healthcare Income Fund

CML Healthcare Income Fund (OTC: CMHIF, TSX: CLC-U). Yield over 7%. Buy under 11. Yield over 7%.

While Canada's health care system is far more socialized than that of the US, it's still possible for well managed, efficient companies and trusts to profit in Canada’s health care system. In fact, given Canada's traditionally more paternal the government commitment to funding the system, business is actually even steadier than in the US, making healthcare one of the most reliable sectors.

Reliable high yields in healthcare are very hard to find, and this is the best I've seen. It provides testing services and has begun expanding into the US. They reported first quarter revenue growth of 38.6 percent and double-digit cash flow growth, which in turn drove its payout ratio down to a comfortable 84.6 percent.

The keys to success:

· Successful US expansion,

· Steady income from current operations

· Rate increases at the Canadian operations

· New cost controls

These trends should continue to show up on the bottom line for the rest of the year, even as the trust boosts efficiency by digitizing its information network. A veteran player in Canada’s national medical industry, CML is well positioned to profit richly from President Obama’s moves to increase the government role in the US. As an established player, it has the financial strength to make that happen as opportunities arise.

4. CONCLUSION

My only reservations about buying these firms are:

· Both are above my buy limits as of the time of this writing

· Both are thinly traded and thus potentially volatile

· There is plenty of overall market risk given both

ü The likely fraudulent and one-time nature of the Q1 profits that ignited this rally

ü The lack of fundamental (versus technical unwinding of short positions) underlying justification for the rally's continuation

Thus keep these in mind when their prices come in.

Disclosure: The author owns shares in the above companies.

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THREE MUST-KNOW OPTIONS STRATEGIES FOR DIVIDEND INVESTORS: For Lower Risk AND Higher Yield

 

 

1. Introduction

For dividend income investors not familiar with options, here are some simple, ideas you should consider for getting higher yields with little or no additional risk.

This article is intended purely to introduce some simple, conservative options strategies for both decreasing risk and increasing income. Dividend investors who are often unfamiliar with options, can then decide if these are worth further investigation. Readers will need to do more homework before implementing these strategies, and stay tuned for follow up articles in this blog or in my newsletter, The High Dividend Stock Guide. See below for some additional resources.

A. Options Need Not Be Risky or Complex

Most dividend income investors tend to be risk averse and prefer the simplicity of buying and holding quality stocks with reliable yields. For most dividend investors, the very word “options” connotes high risk and complexity.

In fact, there are options strategies that are simple, and can increase your annual yield with little or no additional risk. The level of risk and complexity varies completely with how you use options. It's like comparing auto racing to conservative driving. Both can be called driving, however the risk and skill levels demanded by the two activities differ dramatically. The same goes for options trading.

Again, used properly, stock options can actually reduce risk and increase your income.

B. Why Dividend Investors Should Consider Options

How would you like to make an additional 5%-10% or more annual yield on stocks you already own, and plan on holding? It’s possible by selling Covered Call options, which are just rights to buy your stock.

Are there stocks you would love to buy if they drop to a certain lower price? Rather than simply placing a buy order at that price, you can sell a put option, which is a contract to buy someone’s shares if they sink to a certain price. Your put option buyer gets insurance against a price decline below that price. You get the stock you’d have bought anyway – at a further discount equal to the put option sale price.

For overall portfolio insurance against market declines, you can buy put options on a major index or surrogate of an index.

C. Basic Concepts

Here’s the basic vocabulary of stock options.

1. Definitions

An option is short for an options contract, which is a formal agreement providing the right (but not the obligation) to buy or sell a fixed number of 100 shares of a given stock on or by a specific date called the expiration date at a specific price called the strike price. Note that options typically trade in units of 100 shares called contracts. Thus instead of selling options on 300 shares, you’d sell three contracts. So if you trade online, you’d enter ”3” not 300 in the Quantity or Amount field when placing your sell order, otherwise you’ll be selling options on 30,000 shares. Your trading platform will alert you if your portfolio isn’t large enough to cover that, but if it is, you could make an expensive mistake.

2. Two basic kinds of options:

A call option is a right to buy. Visualize calling someone over to give you the shares for which they have sold you the right to buy at a given strike price and by a given expiration date.

There are two kinds of call options. Covered calls are rights to buy stock that the seller already owns, so he is "covered" against the risk of needing to buy shares that have suddenly risen in price in order to fulfill his obligation to the buyer of the call option on the expiration date.

FYI, selling naked calls means selling calls on shares the seller does not currently own, and who risks being forced to buy shares that have unexpectedly risen in order to fulfill his obligation, just like any short seller. This strategy IS obviously more risky and beginners should avoid it.

A put option is the right to sell. Visualize your putting the shares into a buyer's hands.

3. The Price of an Option is Composed of Two Parts

Intrinsic value: Is simply the REAL value of the option if exercised at a given moment. If a stock sells for $10/share, an option to buy the stock for $5/share (i.e. a call option with a $5 strike price) is worth about $5/share, or $500/contract, since the owner could exercise the option and save that amount.

Only options that are in-the-money have intrinsic value.

That is, a call option (right to buy or call in) has intrinsic value only to the extent that its strike price is BELOW the market price, because it gives the owner the right to buy the stock below market value.

A put option (right to sell or put into the put option seller’s hands) has intrinsic value to the extent that its strike price is ABOVE the stock price, because it allows the owner to sell the stock above market value.

Time value: The value of the time left to exercise the option. An option is a right for a specified time. The more time left on the option for the price go in the owner’s favor, the more time value and the higher the option price.

4. In General, Sell Options, Don’t Buy Options

Thus time works in favor of option sellers, and against option buyers. An option buyer must not only be right about the direction of the market (hard enough), but the timing as well, because the option becomes worthless after the expiration date. Thus the time value portion of the option is always dropping.

Unless you’re buying puts (rights to sell) as insurance, option buying is a riskier strategy better suited to those with more trading skills and/or risk tolerance than the typical income oriented investor.

In general, conservative income investors stick to selling options, except for buying index puts as portfolio insurance

Sell covered calls to enhance yield on stocks you own.

Sell puts in order to buy stocks you would buy at the strike price anyway in order to get them for even less, thus enhancing yield AND reducing risk of loss with a lower cost basis.

Below we will provide a brief introduction or review of some of the most basic options strategies for enhancing yield, reducing risk, or both.

2. Selling Covered Calls

Did you know that it’s very possible to earn an extra 5%-10% annual yield (or more) on stocks you already own? You could do it by selling a call option (an option to buy from you) on those shares at a price that’s a bit higher than the current price. Because you already own the shares, this call option is called a covered call. In other words, you’re covered against the risk of needing to buy the shares at a price above your strike price.

A. Advantages

If you plan on holding the shares, there is no additional risk, because you’ve already assumed the risk of stock ownership.

There are only two possible outcomes, both of which are better than simply holding your shares.

· If, on the expiration date of the call option, the stock price rises above the price you specified, the strike price, your stock gets called, or sold at the strike price. You’ve lost nothing except the potential gain above the strike price. Again, if you planned on holding the stock, you wouldn’t have gotten that anyway.

· If the stock is below the strike price at the expiration date, the covered call option expires. You keep the stock and the sale price or premium.

In either case, you pocket the extra cash from selling the covered call option.

Obviously, we want to sell covered calls at a strike price above our cost basis, so we still profit if the market price is above the strike price and the shares are called. Ideally we’d like to sell at a strike price above where we believe the price will rise by the expiration date, so that we can keep both the premium and the shares.

B. The Tricky Parts

Timing: The hard part is in the timing. The more the options are out-of-the-money, i.e. the more the strike price is above the market price, the lower the value and price of the option, since the buyer has a higher risk of the option expiring worthless.

So covered call sellers ideally try to sell calls at market peaks. Few are good at market timing.

Option Price Increments: Unlike stocks, options are not sold in penny increments, rather at increments of between $2.50 and $5.00 or more, depending on how high the stock price. Thus you can’t always trade options at prices that will cover your cost basis AND give you a decent return.

C. Disadvantages

When you sell covered call, you risk missing at least some of an unanticipated rise in the stock price. If your strike price was below your cost basis in the stock plus the cash from the option sale, you risk a loss either from selling the stock at a loss or buying back the call for more than you sold it.

3. Selling Put Options on Stocks You Want to Own

Is there a stock you’d like to buy once it gets down to a certain lower price? How would you like the chance to buy at that low price, with an additional discount? You could do it by selling a put option (option to sell to you) on that stock at that desired strike price.

A. Advantages

There are two possible outcomes, both of which are better than simply putting in a buy order at the given price.

· If, on the expiration date of the put option, the stock price is at or below the specified strike price, you pay for the stock at the price you wanted, with an additional discount in the form of the premium you were paid up front when you sold the option.

· If on the expiration date of the put option the stock is above the strike price, the buyer does not sell to you. You got paid for providing insurance to the buyer of the put option against a price drop below the strike price.

Again, in either case, you keep the premium from the sale of the option.

B. The Tricky Parts

Obviously, we want to sell covered calls at a strike price at or near strong support, at what we consider bargain levels. Ideally we’d like to sell at a strike price below where we believe the price is likely to drop by the expiration date, so that we can keep both the premium and the shares.

As with selling covered calls, the tricky part is in the timing. The more the options are out-of-the-money, i.e. the more the strike price is below the market price, the lower the value and selling price of the option, since the buyer bears greater risk of the option expiring worthless.

So put sellers ideally try to sell at market bottoms. Few are good at market timing.

Option Price Increments: Unlike stocks, options are not sold in penny increments, rather at increments of between $2.50 and $5.00 or more, depending on how high the stock price. Thus you can’t always sell put options at strike prices that are low enough to want to buy the stock, AND to get a good premium on the sale of the put.

A. Disadvantages

When you sell a put, you risk “catching a falling knife,” that is, being obligated to buy a stock after its price has plummeted, and you wind up taking a loss either from buying a stock well above its market value or buying back the option for more than you sold it.

4. Buying Put Options on Stock Indexes or Their Surrogates for Overall Portfolio Insurance

Even an introduction to this strategy requires its own article, since this strategy can get complicated. For now, know that you want to take a certain portion of your dividend yield and use it to buy put options on an index or surrogate for one. For example, if you own a general portfolio, puts on the S&P 500 index or SPYs would work. Those heavy in energy would seek to dedicate a portion of their dividends to buy puts on something tracking energy. The idea is to get some insurance without gutting your returns. More on this at a later time.

5. Options are Not Always Available

You may not be able to trade options on thinly traded and/or foreign shares, especially if you only trade on U.S. exchanges. Fortunately many of our recommendations do have options, including most of the more liquid foreign ones.

BP, plc (BP), CNOOC Ltd. (CEO), Enid SpA (E), Total Fina Elf (TOT), Veolia Environmental SA (VE), AT &T Inc (T), Verizon (VZ), Otelco (OTT), Windstream Corp (WIN), Buckeye Partners (BPL), El Paso Pipeline Partners (EPB), Enterprise Products Partners (EPD), Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), Nustar Energy (NS), ONEOK Partners (OKS), Sunoco Logistics Partners (SXL), TEPPCO Partners (TPP), Tortoise Energy Infrastructure Partners (TYG), Alliance Resource Partners (ARLP), Northern Resource Partners (NRP), Penn Virginia Resources Partners (PVR), Terra Nitrogen Company, L.P. (TNH), StoneMor Partners (STON) Dominion Resources Inc. (D), Duke Energy Corp (DUK), Progress Energy (PGN), Southern Company (SO)

6. Sources for Further Study

If the above strategies sound intriguing, you'll need to do more homework. Here are a few free sources for getting started.

A. Free Online Resources

Any internet search using various combinations of terms as

· "stock options" AND (introduction OR guide OR beginner)

· "options" AND "investing

· "options strategies" AND stocks

will provide you with numerous well written, more detailed introductions to the topic. A few sites to browse for introductions to options and terminology include:

· http://finance.yahoo.com/

· http://www.investopedia.com

· www.rongroenke.com (for ordering the books mentioned below and further materials for implementing his strategies)

B. Books

There are many. Here are a few suggestions that would be an excellent start for high dividend and others who invest in stocks for dividend income.

Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income by Ron Groenke, Keller Publishing, 2004: (Order via www.rongroenke.com or other online sellers). I actually read an earlier version called Covered Calls and Naked Puts, this is an updated version.

This book is one of the most mercifully clear, jargon-free and concise introductions to simple options strategies for income, yet at the same time provides fairly detailed explanations of how to implement the strategies discussed. Written as the story of a retiree who reunites with his old college Finance Professor in a Florida retirement community, the author explains his techniques through dialogues between the two men. The story slows down the information flow a bit, but many will find the book far easier to read than a typical book on the topic.

Put Options by Jeffrey M. Cohen, McGraw Hill, 2003. The best book I’ve found on how to use puts for both income reduction and risk. Some new twists on using puts, very worthwhile specifically for conservative, risk averse income investors. Great ideas, clear and well explained.

7. Conclusion, Disclosure & More Info

Disclosure: I have positions in most of the above mentioned investments.

Interested in learning more about investing in stocks that provide reliable high dividends with better transparency, appreciation potential, and liquidity than bonds? Visit http://highdividendstocksguide.blogspot.com