January 5, 2015
Underperforming Market May be
About to Stage a Massive Turnaround
By Joseph Hogue
For years, the stock market mantra has been, "Don't fight the Fed." Despite slow global growth, multiple geopolitical incidents and a struggling U.S. economy, the historic monetary program enacted by the Federal Reserve has driven stock prices higher.
While U.S. stocks are not particularly expensive compared to prior bubbles, the Fed wrapped up its bond-buying program and is ready to start hiking interest rates sometime in 2015.
Even against the potential for stronger economic growth on lower energy prices, I can't help but wonder if the mantra is now warning investors of risks in U.S. stocks. If monetary stimulus can send markets higher even against weak economic data, will a restrictive monetary policy send shares lower even during good economic times?
Fortunately, there is a market that should see strong gains in 2015 even as the Fed is taking the punch bowl away.
It's not Japan where the Bank of Japan has engineered its own stock market rally with an aggressive monetary program. The Nikkei 225 jumped 63% in the past two years, but Prime Minister Shinzo Abe is having a tough time launching the final arrow of his reform program, and record spending has yet to translate into real growth.
The best place to buy in 2015 also isn't in emerging markets. An oversupply in energy markets and slower growth in China have precipitated a plunge in commodity prices. Markets dependent on commodity exports have plummeted, and U.S. dollar-denominated investors have been hit even harder on weakening currencies.
It could be that the best place to be in 2015 is where returns have underperformed for the past several years and where the central bank may be ready to get the party going.
ECB Running Out of Excuses
As of yet, the world has not seen much from the European Central Bank (ECB). A half-hearted series of bailouts and loan programs have kept the region from total economic collapse, but the monetary hawks in the central bank have limited any real stimulus. In fact, the return on the ETF that I prefer has trailed the S&P 500 by 125 percentage points since the March 2009 market trough.
First the ECB said that the region needed fiscal discipline, but draconian spending cuts failed to stabilize the markets and bring investors back. Then the bank said that monetary stimulus would lead to runaway inflation, but pricing pressures never materialized.
ECB President Mario Draghi has talked a good game and promised the bank would do "whatever it takes," but other members of the central bank have restrained policy.
According to Ernst & Young, the economy of the European Union likely barely saw positive growth of 0.8% last year and may not do much better in 2015 with a forecast of 1.2% growth.
Recent programs like the four-year targeted longer-term refinancing operations (TLTROs) of bank loans have underwhelmed investors, and new problems in Greece sent markets lower again. The ECB holds its next monetary policy meeting on Jan. 22, and three non-monetary policy meetings before the end of February.
There is good reason to believe that the ECB may become investors' best friend this year.
There are really few excuses left for the central bank to hold back on monetary stimulus. Inflation in November fell to just 0.3% on an annualized basis, well under the bank's target of about 2%, and making deflation a very real threat. The drop in energy prices means inflation will likely be subdued for most of 2015 and gives the bank a lot of leeway.
Besides the upside to economic growth from monetary stimulus, valuations are much more attractive in shares of European companies compared to domestic U.S. stocks. My preferred ETF, iShares MSCI EMU (NYSE: EZU), trades for 16 times trailing earnings, well below the multiple of 19.7 for the S&P 500 index.
The energy sector makes up just 5.5% of EZU, the smallest weighting of 10 sectors. Continued weakness in energy prices could mean higher profits for consumer discretionary and industrials, which make up more than 26% of the fund.
Hedging Optimism With an Options Strategy
Europe's economy will not turn on a dime, and there is still the chance for disappointment from the ECB, so I am hedging my optimism with a put selling strategy.
By selling a put option on this fund, we are agreeing to buy 100 shares per contract at the option's strike price if shares are below that price when the option expires. For accepting the obligation, we are paid a premium, which lowers our cost basis. And if shares are above the strike price at expiration, that premium is ours to keep free and clear.
This is the perfect strategy for when we believe that while shares may not zoom higher, the downside is limited and strong forces should at least support prices. It allows us to generate income while we wait for those forces to send shares higher.
With EZU closing Friday at $36.37, we can sell the EZU Feb 37 Puts for a limit price of $1.40 a share ($140 per contract). If EZU closes below the $37 strike price at expiration on Feb. 20, we will be assigned shares at that price. Since we received $1.40 in options premium, our actual cost is $35.60 per share, a 2% discount to the current price.
We want to make sure we have enough money in our account to cover the purchase. This means setting aside $3,560 for every contract plus the $140 we collected from selling the puts.
If EZU closes above $37 on expiration, we keep the premium for a gain of 3.9% in just 47 days. If we were able to make a similar trade every 47 days, we would generate a 31% annual rate of return.
If we are assigned shares, we can sell covered calls every couple of months to bring in more income.
While stocks in the euro zone have disappointed investors over the past several years, regional funds look poised to provide strong returns this year. Investors could also play this theme with the Vanguard FTSE Europe ETF (NYSE: VGK), but I do not like this fund for a put selling strategy because of its high 4.3% yield. If you choose VGK, you may want to use a covered call strategy so you can collect dividends.
Note: Selling puts is one of the best strategies for generating consistent, market-beating returns. My colleague, Amber Hestla, has earned 43% average annualized gains with this strategy on her way to a perfect 78 for 78 track record. Get the details about those winners and learn how you can make the same trades by following this link.
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