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Third Year Of A Bull Market
March 9th marked the second birthday of the current bull market. A good time to examine the history of bull markets to see what might lie ahead during this coming third year.
Bull Market History
On the one hand we know that 3 of the last 10 bull markets since 1949 have stopped short of their third year birthday. However, said another way, that means 7 of the 10 made it to the third year mark with bull market in tact. But these kinds of statistics always involve a small sample size and invariably have special circumstances the prior markets did not (e.g. potential nuclear meltdown, QE2 coming to an end in a couple months, uprising in multiple Middle East countries, etc).
Most professionals expect the bull market to continue, albeit at a much slower rate of gain than we have seen the last two years. Considering that these first two years saw the S&P 500 rise by 95%, it is reasonable to assume a flattening of the growth going forward. In fact, the S&P 500 has had an average return of 3% during the third year of a bull market.
The biggest risk to the stock market is rising interest rates. With QE2 slated to end in June, who will step in to purchase the $110 billion/month in treasuries that the Fed has been buying ($75B/month in new purchases and $35B/month in reinvestment purchases) at today's prices? And if the answer is 'no one' then prices will drop until buyers are found. Lower prices for treasuries translate into higher interest rates.
Bull Market With Inflation
So, what should you do during the third year of a bull market when you expect increased inflation? Here are five ideas:
1. Buy TBT and sell calls against it. As mentioned in our Rising Interest Rates article from January, TBT is an inverse bond ETF that will go up as interest rates go up. Because it is leveraged 2x you'll want to do more in-the-money than you normally do. Sell the near-month option each month, rather than a multi-month option. Medium-term (next 6-12 months) the odds of TBT dropping much are small unless we get a surprise and experience deflation instead of inflation.
2. Sell your bonds, or at least some of them. Unless you plan to hold them to maturity, are happy with the interest rate you are getting until then, and are not worried about default, then why hold something that is for sure going to fall in value as interest rates rise? If you have money in bonds that you will need before the bonds mature then selling them now will probably be a better outcome than selling them in a year or two when rates are higher.
3. Buy GLD (gold ETF) and write calls against it. Normally gold rises during periods of inflation. Everyone should have at least a little gold exposure.
4. Buy commodity-based stocks and ETFs, and then write calls against them. Traditional inflation hedge, commodity-based companies tend to see increased profits as inflation rises. Many of them have good premiums for writing covered calls.
5. Don't hoard cash if rates begin to rise. Inflation reduces the real-world buying power of cash. Rather than hold cash, buy some broad-based ETFs and sell in-the-money calls against them. You will get some downside protection because of the intrinsic value of the in-the-money options you're selling and you should be able to earn significantly more yield than what interest on cash pays.
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.