The Value Line Daily Options Survey

Positioning Our Covered Call Portfolio For 2009

The U.S. economy continues to deteriorate, with 533,000 Americans losing their jobs in November. In the first 11 months of 2008, the economy shed almost two million jobs. Initial unemployment claims in the first week of December surged 58,000 from a week earlier to 573,000, a 26-year high, and most expectations are that the nation’s unemployment rate will rise from 6.7% last month to more than 8% in 2009. According to the National Bureau of Economic Research, a recession began last December, and recent data concerning consumer and corporate retrenchment don’t augur well for an early end. Indeed, none of the consumer and industrial markets that we view as critical to a sustained revival, such as housing, retail, and manufacturing, appears to be very close to bottoming out. Our sense is that macroeconomic activity will continue to contract in 2009’s initial half, and then, perhaps, begin to rebound unevenly, with the timing and velocity depending, to some degree, on the magnitude and effectiveness of the incoming Obama Administration’s much-anticipated fiscal stimulus package.

The stock market, meantime, has had a year that most investors would clearly like to forget. With only a few trading sessions left in 2008, the Dow Jones Industrial Average is down 35.4% (as of the close of trading on December 15th), while the broader Standard & Poor’s 500 Index has fared even more poorly, with a year-to-date loss of 40.8%. That said, equities have behaved reasonably well since November 21st, the date that word first leaked that President-elect Barack Obama would be nominating Timothy Geithner, the president of the New York Federal Reserve Bank, to be the next Treasury secretary. This nomination and expectations of the aforementioned stimulus package appear to have provided investors with some reassurance, as has a growing perception that the stock market bottomed on November 20th, when the S&P breached levels last seen in April of 1997. Our view is consistent with this perception, as spelled out in great detail in our December 2nd report (see file ot081202 in our archives). With this in mind, in this week’s report, we discuss the year-to-date performance of our Model Covered Call Portfolio, review its parameters, and position it for 2009.

Our Performance

The portfolio fared relatively well through the first eight months of 2008. At the end of August, it actually had a positive return of 0.6%, compared with a 12.6% loss for the S&P 500. Its performance in the subsequent three months were decidedly subpar, with losses of 9.5%, 17.3%, and 13.2% in September, October, and November, respectively. By contrast, the benchmark index fell 9.1%, 16.8%, and 7.5% in the comparable periods. As of December 15th, the Model Covered Call Portfolio had a year-to-date loss of 34.7%, which is still 6.1 percentage points better than the S&P 500. The recent underperformance reflects extraordinary weakness in two maritime-sector holdings (Genco Shipping and Kirby), which we added in June, just as the Baltic Dry Index, which tracks the cost of shipping raw materials, such as steel, coal, and grains, was poised to plunge from record levels. Our results were also hurt by belated selling in several healthcare stocks, including Medtronic and Stryker, that perhaps was triggered, in part, by hedge and mutual fund redemption, as well as by margin calls.

With the diagonal backspread, you also buy the options that are out-of-the-money and sell a lesser number of options that are in-the-money; however, with this spread the options you write are closer to expiration than the ones you buy. Diagonal backspread opportunities often emerge in volatile, high premium, markets (such as we have been experiencing). With a call diagonal backspread, for instance, you can take advantage of the fact that when investors are nervous, the nearer-term lower-strike options are often overpriced, while the longer-term higher-strike options can remain fairly priced.

A Reminder of The Parameters

In establishing our Model Covered Call Portfolio in late February, 2006, we picked stocks that were ranked 1 or 2 for year-ahead Timeliness and at least 3 (Average) for Safety; we retained the flexibility to keep stocks whose ranks had dropped to 3 for Timeliness. To qualify for inclusion, a stock also had to offer at least average 3- to 5-year capital appreciation potential. In addition, in order to achieve substantial diversification, we limited our exposure to any one industry to no more than two stocks.

We also tried to achieve some diversification when deciding which options to write. We set the strike price on one-half our stocks at about 5%-10% out-of-the-money, one quarter at very close-to-the-money, and the last quarter at about 5%-10% in-the-money. The expiration dates were staggered to provide some allowance for market volatility and to increase the generation of premium income. (See our March 5, 2007 and April 2, 2007 reports for a detailed review of the characteristics and investment objectives that were considered in the construction of the portfolio; files ot070305 and ot070402.)

Portfolio Considerations and Adjustments

As noted previously, our view is that the market has either already seen the bottom or is very close to one. Moreover, considering the global economies’ myriad problems, we think a recovery in equities will be both gradual and choppy. Given this outlook, we’re inclined to maintain our recent strategy of writing mostly close-to-the-money calls for the foreseeable future.

As we prepare this report, scheduled to go to press on December 17th, the Model Covered Call Portfolio contains six stocks (Qualcomm, Kirby Corp., Cisco, Disney, Genco Shipping, and Transocean) that are ranked 3 for Timeliness. It is also short five options (Microsoft, Walgreen, Qualcomm, Kirby, and Stryker) that are scheduled to expire on December 20th.

Qualcomm, Cisco, and Disney are neither timely nor are they components of timely industries. So, even though we like each for the long haul, we have replaced them with the shares of Oracle, Unilever, and Kraft Foods, the first a member of the Computer Software/Services sector, and the other two members of the recession-resistant Food Processing group. We have decided to retain Kirby and Genco for now, though, for the following reasons. Both stocks have shown some strength in recent days as the Baltic Dry Index has spiked upward. Moreover, unless Wall Street analysts are considerably off the mark, these stocks are vastly undervalued. The average share-earnings estimate for Genco in 2009 is $5.29, based on 16 estimates that range from $4.05 to $6.90, while the average for Kirby is $3.16, based on 12 estimates that range from $2.78 to $3.35. We are also keeping the shares of Transocean, because, they, too, seem cheap at just 3.7-times the consensus (41 estimates) 2009 figure of $15.45. That said, we will most likely roll down the strike prices on all three positions later this week.

We remain favorably disposed towards all of our 1- and 2-ranked holdings. Given the deterioration in the price of several holdings, however, we will make multiple changes in our short option positions. Invariably, this will entail closing out calls that are far-out-ofthe- money and writing calls that are closer-to-the-money. In most cases, we will also roll out to later expirations. The stocks requiring near-term attention are Microsoft, Stryker, IBM, and Waters Corp. We will make these changes later this week, since the stock market currently seems to have an upward bias, inhibited somewhat by anxiety over a possible bailout of the U.S. automakers by the Bush Administration. (Note: Figure 1 on page 4 is a snapshot of our portfolio at the close of trading on December 15th. All forthcoming changes will be posted on our website on December 22nd or 23rd.)

Prepared by George Rho
Senior Options Strategist
vloptions@valueline.com