Rise of the Machines

There’s no way around it: The past week has been brutal for investors of all stripes.

At the same time, a broad-market correction has been long overdue. Indeed, toward the end of January, the S&P 500 was trading at a price-to-earnings ratio of 23.2, or a nearly 32% premium to its long-term average.

After the beating it’s taken, the S&P is back to a P/E of 20.6, which though still elevated is much more reasonable compared to just a couple weeks ago.

So a correction should ultimately be healthy, even if some of the circumstances surrounding this one are deeply unnerving.

For instance, even if you want nothing to do with cryptocurrencies such as bitcoin, you have to wonder what sort of liquidity crises their crash may have created in the weeks leading up to the market’s current tumult.

Then there are all the investors who made small fortunes shorting volatility using leveraged exchange-traded notes amid the bull market’s complacence only to see their bets blow up this week when volatility returned with a vengeance.

You would think the professionals might know better than to dabble in some of these areas, but Wall Street and the world’s other money centers go wherever there’s a buck to be made. As such, there may be some big institutions whose bruisings from these plays bled over into the stock market.

As a numbers guy, I don’t follow the Dow Jones Industrial Average as closely as I do the S&P 500. For all its faults, the S&P, with its 500 or so stocks, generally offers a better snapshot of what’s really going on in the market than the 30 blue chips in the Dow.

But I couldn’t help notice the apocalyptic turn the Dow suddenly took on Monday afternoon.

Up until 3 p.m. or so, the market was having a moderately bad day, but nothing out of the ordinary.

But in a matter of minutes, the market took an ominous turn for the worse. Then, it nearly fully recovered before heading back down again.

Source: Bloomberg

That kind of action is reminiscent of the Flash Crash. And it makes me wonder if some trading whale accidentally fat fingered their keyboard—or if whatever passes for HAL-9000 among program traders executed a bad line of code.

One journalist joked about the prevalence of program trading by tweeting a photo of an impassive wall of computer servers with the caption, “Sad photo of Wall Street traders reacting as stock market plunges.” Indeed.

In a more conspiratorial bent, I often wonder how much of market, sector, and stock volatility is driven by our new algorithmic overlords—because that chart of the Dow does not look like something humans could have done unless it was an accident.

And yet, since then those 15 minutes have clearly spooked the market’s constituents—both human and computer alike.

The thing that gives me solace, however, is that there’s a pretty favorable economic backdrop underpinning the market, while it shakes off its excesses.

Though bond yields and interest rates are rising, they still aren’t all that far from their historic lows.

And the regulatory rollback coupled with tax reform seems to have breathed new life into business sentiment and, more important, business investment.

Meanwhile, the U.S. is pretty much at full employment and wages are finally starting to head higher.

The recovery since the downturn has been so anemic for so long, that I’ve been pretty skeptical about the true health of the economy for quite a while. But I have to acknowledge that notwithstanding the market’s recent action, things are starting to look pretty good.

Although we may learn the cryptocurrency meltdown and short-vol trading bust wounded some surprisingly big players, I don’t think any of that is enough to throw us into a bear market.

A formal correction is marked by a decline of 10% or more on a closing basis from a trailing-year or all-time high. A formal bear market is marked by a decline of 20% or more on a closing basis from a trailing-year or all-time high.

With those thresholds in mind, let’s see how both the broad market indexes and key sector benchmarks stack up. As I write this, it’s a little more than two hours before the market’s close, so these numbers could change materially between now and then.

Since hitting all-time highs on Jan. 26, the Dow and the S&P are off 11.1% and 11.3%, respectively. Of course, that all happened pretty quickly.

By contrast, key sectors for dividend stocks started declining in earnest at the beginning of December, even if they posted their highs a couple weeks prior to that.

The three main utility benchmarks hit all-time highs in mid-November. Since then, they’ve fallen by an average of 16.1%.

REITs hit their trailing-year high around that same time. The main REIT benchmark has since dropped 14.1%.

MLPs are a bit trickier to judge, since they’re still recovering from the energy crash. But they saw a nice rally from the end of November through most of January, so we’ll measure the latest carnage from the latter. Since Jan. 23, the Alerian MLP Index has fallen 12.1%.

The bottom line is that while this correction may be worrisome, it’s not a bear market yet. And given the favorable economic backdrop, even if the market hits technical bear-market territory, I don’t expect it to remain there for long.

How to Get Instant Income

Last week, I announced that we’ll be enhancing our income-generating opportunities with a new trading strategy—one that can create dividends out of thin air during the enter life cycle of stock ownership.

To recap, we’ll create instant payouts while waiting to buy a stock we want to own at a more reasonable price. Then, once we pick up shares at a discount, we’ll collect the dividend and wring even more income from the stock as we prepare to sell it after it reaches full value. Wash, rinse, repeat.

If you haven’t guessed already, this strategy will involve the use of options. If you’re not comfortable with options, that’s fine—we’ll still be on the prowl for new dividend stocks and continue to track our existing portfolio recommendations.

I’ll discuss the specifics of the strategy in further detail next week. But the general idea is that instead of using limit orders to buy and sell stocks, we’ll be selling put and call options for the same purpose.

That way, we get paid good money to buy high-quality dividend stocks at a discount. And we’ll also get paid good money—more than just the capital gain from share-price appreciation—to sell them at a premium.

With standard limit orders, you pay your broker for the privilege of these transactions. Now, you’ll get something in return above and beyond what a trade typically nets you, while further limiting risk.

Normally, when you set a stingy limit to buy a stock, you may have to wait weeks or even months for your order to fill. Meanwhile, your money is sitting idle in your account.

When we sell a put option for the same purpose, we get money up front. And if we don’t get the stock when the put expires, then we can sell another put.

If the stock never gets put to us, we win by creating what amounts to regular quarterly payments without the risk of stock ownership.

If the stock does eventually get put to us, we still win because we’ll be buying a high-yielding stock we’d want to own anyway at a nice discount to where it was trading when we sold the put.

Then, we’ll sit back and collect the dividend until the stock approaches full value. At that point, rather than setting a sell limit at a premium price, we’ll sell a call with a strike at that premium price instead.

If the stock doesn’t get called away, we win by enhancing the stock’s dividend stream with additional income from selling covered calls. If the stock gets called away, we win by selling the stock at a premium and getting paid to do it when we sold the contract that made the transaction happen.

Some of you may use one or more of these techniques already, while for others this will be entirely new territory.

If you’re new to this, options can be a lot to wrap your head around, so I’ll be writing in greater detail about put and call options next week.

For now, if you’re interested in participating in this strategy, you’ll need to secure the appropriate authorization from your broker.

You should be able to do this through your existing broker, but if you’re interested in finding out which brokers offer the best options service, then this guide may help you choose the right one.

Different brokers have different trading levels, so call your broker for guidance.

For example, Fidelity requires trading level 1 for covered calls, level 2 for selling 100% cash-secured naked puts, and level 4 for reduced-margin naked puts.

By contrast, Charles Schwab requires trading level 0 for covered calls, level 1 for 100% cash-secured naked puts, and level 3 for reduced-margin naked puts.

Since we’ll only be selling puts on solid stocks we’d want to own anyway, we recommend keeping the necessary cash to make the purchase in reserve in your brokerage account—that means only selling cash-secured puts. This ensures you’ll have the cash on hand necessary to buy the stock without having to worry about the possibility of a margin call.

If, however, you’re an aggressive investor who’s comfortable with risk, then you can put more of your money to work by setting up a margin account. With a margin account, the initial capital requirement per trade is much less—only 20% to 25% of the purchase price of 100 shares per contract vs. 100% of the purchase price in a cash account.

Keep in mind that the reduced capital requirement of a short put in a margin account is not fixed but can increase after trade initiation if the stock price drops in value.

If you do set up a margin account, federal regulations require that you maintain at least a $2,000 balance in that account.

Again, we recommend that you only sell cash-secured puts since our goal is to eventually own the stock anyway. But that decision is ultimately up to you.

Applying for the appropriate clearance now should give you enough time to receive approval from your broker before our first round of trades in a couple weeks.

If for some reason your broker doesn’t give you the clearance that you sought, then you’ll need to reapply for approval and answer their questions more aggressively, though honesty is always the best policy.

Several of the trading platforms, including TD Ameritrade’s thinkorswim and Charles Schwab’s OptionsXpress, allow you to do “paper trades” as a way to practice options trading using fake money.

Paper trading is a great way to increase your trading experience (and confidence!) so that you can reapply for a higher trading level than you were initially granted.

Read more about paper trading here and then start placing trades exactly as if you were using real money.

Portfolio Update

CNX Midstream Partners LP (NYSE: CNXM) continues to suffer from uncertainty now that Noble Energy (NYSE: NBL) is no longer in the picture.

That’s despite the fact that Noble sold its stake in the joint venture with CNX Resources (NYSE: CNX) to an entity—Houston-based private-equity firm Quantum Energy Partners and its affiliate HG Energy—that will almost assuredly give CNXM more attention than Noble could.

Though we expected the MLP to provide clarity on its new co-sponsor’s plans, it looks like we’ll have to wait until the company’s analyst day on March 13 to learn more about them. That’s because CNXM was mostly mum about that during its earnings call for the calendar fourth quarter.

Keep that date in mind because it could be a key deadline for picking up CNXM before management gives the market a potential catalyst to send shares higher.

Because Wall Street analysts are mostly in the dark right now about Quantum and HG’s plans, their base case pretty much assumes the bare minimum of activity. Therefore, consensus forecasts could turn out to be pretty conservative.

Right now, for instance, analysts are forecasting that EBITDA (earnings before interest, taxation, depreciation, and amortization) will decline 15% this year, to $141.8 million. As analysts concede, however, these projections could change materially for the better once they get more information.

With that in mind, let’s review how CNXM did during the calendar fourth quarter. Adjusted EBITDA grew 11% year over year, to $32.4 million, due to lower maintenance spending.

That, in turn, boosted distributable cash flow per unit by 10%, to $0.35, for ample 1.3 times coverage of its $0.3133 per unit distribution. CNXM has grown its distribution by 15.1% over the past year.

Because of the information vacuum and the resulting muted expectations, CNXM looks like one of the most expensive MLPs on a price-to-projected EBITDA basis. Again, that could very well change after next month’s analyst day.

For now, CNXM offers an attractive 6.6% yield, with solid distribution coverage, backed by one of the least-levered balance sheets in the sector.

Given the market’s recent action, prices could fall lower still. To this end, keep CNXM’s trailing-year low of $15.25 in mind. While we’re a long way from that level in percentage terms, I’ve learned to never underestimate the punishment the market can dish out in the short term.

If you don’t already own CNXM, consider breaking up your usual investment into one-third increments. The market may give you an opportunity to establish a lower average cost basis than a lump-sum investment would. CNXM is a Buy.

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