Where To Hide During A Rout
Musings and ideas to end a long week
The past couple of weeks have been characterised by the exact opposite of the ‘everything rally’ that had been coined in recent months.
Wednesday was another brutal day for US equities, with the below chart from Bloomberg showing how the 2.31% drop in the S&P 500 was the first drop of this magnitude since the start of the GFC back in 2007:
It’s not just equities that are getting pounded. Both precious and base metals are feeling the heat, with silver down 11% from the highs last Wednesday and copper also sliding to the lowest level since the end of Q1.
A friend of ours, Arno Venter of Capital Edge, posted a great chart earlier this week flagging up why he isn’t surprised that gold is losing ground at the same time as US equities. Below shows the correlation of different assets to the S&P 500 on the 0-1% percentile of stock returns (the worst-performing days for the index). Note the positive correlation that gold has here of 0.33:
Despite the launch of Ethereum ETFs this week, the coin is down almost 12% this week alone. The mix of headlines is somewhat confusing, with some ETFs reporting net inflows while others are haemorrhaging outflows. Looking at the movement in the spot market tells us that this is likely another case of ‘sell the fact’ with the ETFs going live, coupled with broader weak investor sentiment from other asset classes.
So with various assets flashing red, we end the week with some musing about where to pivot to, with some ideas to generate some yield in this environment.
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Rotate To Defence
For those who want to keep equity exposure but rotate out of MAG7 and tech names, we flagged up on X earlier this week our defence basket.
The performance over the past couple of months (note the move MTD) vs SPY helps to show how this sector has been a hiding place from the broader market:
Why defence? Well, part of the driver has been increased geopolitical tensions. In the latest Q2 results, Lockheed Martin explained how its “people, systems, and platforms have again demonstrated their ability to enhance security in Eastern Europe, the Red Sea, and the Middle East.”
Countries globally are increasing their defence spend, and we feel this trend will continue for at least the next year. In fact, Lockheed Martin already has a $160bn order backlog for defence technology solutions.
Many see the sector as a place to rotate due to the stability of revenue and income generation. For many operators, the bulk of business comes from direct dealings with multi-year Government contracts. With a low likelihood of default and payment instalments along the way, it makes it easier to forecast revenue for the future order book. At a time when investors are rapidly revising expectations of growth for some tech names, defence is an appealing place to hide.
If you would like to see the stocks we’ve included in our defence basket, please DM us.
Selling Covered Calls
For investors who don’t want to exit positions completely or those who don’t want to / can’t take on outright short exposure, the blow can be potentially softened by selling covered calls on existing holdings.
EXPLAINER: Selling Covered Calls
A call option gives the buyer the right, but not the obligation, to purchase the underlying asset at a predetermined price (the strike price) within a specific time frame.
Calls can be bought or sold. If sold, the seller receives an upfront premium. Should the underlying asset price not finish above the strike price, or if the buyer chooses not to exercise the option, the seller gets the maximum reward, i.e. the premium.
The options can be sold either ‘naked’ or ‘covered’. Naked selling is where the seller doesn’t already own the underlying asset. This is a high-risk trade, as the losses are potentially unlimited. However, if the seller does own the asset, we refer to the option as being covered. Namely, if the asset rises and the option is exercised, the seller forgoes any upside and simply delivers the asset to the buyer.
The reason why we like selling covered calls in the current environment is because it can provide additional income during the move lower.
For example, after the latest results, Tesla shares fell by 12% on Wednesday trading. Caught up in the broader MAG7 beating, some might argue that there’s more downside ahead in the coming weeks.
Let’s say we bought Tesla shares a month ago at $190. The current share price is $216, with the view that we either move lower or flat line for a month before the dust settles and we get a recovery.
We could sell covered calls with a 1-month expiry at $240 and receive 1.5% in premium. Of course, these levels can be tweaked, to receive more/less depending on the tenor and strike level.
Should we be wrong and end up having to deliver the shares at $240, it’s still booking a profit from the original entry price of $190. If not exercised, then the income is banked.