Don’t Reach for Yield - Take the Easy Dividends and Option Premium

Originally posted at Fox Busness

Yield oriented investors have had a tough time since the financial crisis in 2008.  The old adage, “Don’t fight the Fed,” has rung true as the central bank intervened in the bond market to keep interest rates artificially low.  In order to prop up the economy and allow the United States to service its skyrocketing sovereign debt, the Fed has been actively buying U.S. Treasuries and mortgage bonds, ballooning its balance sheet and destroying savings rates for investors.  

So where is an investor to go for yield when rates are so low and there is abundant interest rate risk in the bond market?  If he stays short he is paid next to nothing and if he extends duration, he is taking on risk that his principal value will fall significantly when rates rise eventually.  I can remember very well when I entered the business in 1994 when investors in “safe” bond funds lost thirty percent in a very short period of time.  If the investor goes down in credit quality for yield, his credit risk increases as well.  Bonds in this environment are usually cheap for a reason.  I say stay out of the bond market all-together.  There is no value there.  Instead, look to equities and collect dividends.  Run a screen and  look for the highest yielding large-cap, blue-chip companies; that is where you can find income in this environment.  If their yield is high, that means the stock price is possibly depressed for some reason.  An investor can collect 2-4% dividends on very high quality companies compared to savings rates of near zero.  Also try and find a stock chart that shows a sell-off and then a long period of building a base.  This means the stock very likely has found a near-term bottom.

At the same time, investors can further increase their income, while decreasing risk, by selling covered calls on these blue-chip equity positions.  By selling the option that the stock could be called away from you at a higher price, you collect a premium.  With the market hitting all time highs and the volatility index at very low levels, it is probably a good bet that you will not be called away any time soon as the equity market is most likely topping out at some time in the near future.  If the equity markets sell off, you have limited your risk by buying undervalued stocks, collecting a nice dividend and additional call premium.  If the markets rally and you are called away on your position at a higher level, the worst thing that can happen is you have bought low, sold high, collected dividends and an option premium.  That’s better than a sharp stick in the eye!  Finally, buy several equity positions to further diversify your risk; somewhere between ten and fifteen positions is perfect.  

The bottom line is that if you are on a fixed income or an investor that has expenditures he has to match to cash flows, there are other options in these markets besides buying fixed income that offers very low yield and comes with a ton of interest rate risk as well.  The combination of high-yielding, blue-chip equities and collecting option premium through selling covered calls, can provide a much higher level of cash flow.  This strategy doesn’t come without risk as equity markets definitely have a downside; however, you can minimize that risk by buying out of favor companies and selling options to give yourself a cushion.  Interest rates only go from twenty percent to zero once in a lifetime.  With rates close to zero, the only way to go is up and your principal is at risk.  As they say on Wall Street, “Interest rates are low until they’re not.”

One Way To Pressure Russia

Originally published in The Moscow Times

The Obama administration’s decision to release 5 million barrels of crude oil from the U.S. Strategic Petroleum Reserve on March 12 signaled to Russia and the rest of the world how the West intends to respond to the Kremlin’s actions in Crimea. It is a harbinger of things to come.

One of the weaknesses that the West has chosen to exploit is Russia’s dependence on energy exports. No matter what you think of the situation in Ukraine, the new global energy realities need to be understood.

The U.S. Strategic Petroleum Reserve was set up after the Arab oil embargo of the 1970s and holds about 727 million barrels of crude oil, making it the largest reserve in the world.

The White House described the March 12 release as a “test release.” However, the timing was not coincidental. It was a shot across the bow of Russia’s petroleum based economy.

The global tension caused by events in Ukraine have actually added to the Russian coffers as the price of crude oil has risen while the ruble has been devalued. By releasing oil from its strategic reserve, the U.S. is telling the world that it has the power to influence the world oil market if it so chooses, and the timing indicates that it considering this course of action in response to events in Crimea.

The Strategic Petroleum Reserve is not the only arrow in Obama’s quiver. For example, he could use his executive authority to waive the 1970 ban on U.S. crude oil exports — the same act of Congress that began stockpiling crude oil. In this way, the U.S. could instantly drop millions of barrels of oil on to the international market. In fact, U.S. refineries cannot handle any more of the light sweet crude being produced in shale regions than they are already processing.

U.S. refineries are geared toward the more heavy oil imported from Venezuela and elsewhere. So, by exporting surplus crude to European refineries, the U.S. could reduce European reliance on Russian crude.

Finally, the U.S. can hit Russia through the natural gas market. The hydraulic fracturing revolution is turning the U.S. in to a net exporter of natural gas. Over the next few years, the U.S. and Europe are expected to expand their liquified natural gas infrastructure, further reducing the European market for Russian gas. In less than five years, the threat of a Russian gas cutoff could ring hollow.

Sure, Russia has the largest reserves of hydrocarbons in the world, but it does not possess the technology to harvest them on its own.

It needs Western support and extraction technology to efficiently develop Russian hydraulic fracturing capability in the north. The West could embargo this technology to slow the growth of this capability.

Additionally, a number of European nations have already started to break away from the global warming craze and develop their own hydraulic fracturing sector. This will further reduce demand for Russian gas.

How would these measures effect Russia?

The hydrocarbon windfalls of the last decade have not led to a modernization of the Russian economy, which would have reduced its dependency on energy exports.

Russian government revenues and consumption remain highly dependent on the oil prices. If the U.S. floods the market with crude, the global price of oil will fall and negatively affect the Russian economy. This might push the economy into a recession and the federal budget into a deficit spending situation.

Meanwhile, Russian borrowing costs on the capital markets have been rising. Russia does have a large foreign currency reserve to cushion the blow, but it will not last forever. These reserves must also be used to defend the ruble against its almost certain devaluation.

The discovery of vast hydrocarbon reserves in the U.S. and elsewhere in the last decade has dramatically altered the geopolitical chessboard and the balance of power in the global energy market.

The recent release of oil from the U.S. Strategic Petroleum Reserves is the first of many validations of this new world order. Russia should take heed of these new realities.

Economic Weakness Creates Military Weakness

Originally posted at Zero Hedge

It has happened over and over again throughout history.  Nations, empires, and dynasties have made bad economic decisions which lead to their own destruction.  The scenario usually goes something like this—one generation sacrifices and works hard to overcome global challenges and creates an economic powerhouse, which in turn allows it to project military power.  Follow on generations take their elders work for granted and ignore and even denigrate the fruits of hard labor, they just want the benefits and start giving away the spoils for free.  The next generation indulges itself in sloth and corruption and is overrun by the barbarians. 

The Roman Empire was famous for giving out bread and circuses to satiate the citizens of Rome, all the while devaluing their currency with less and less precious metal.  They ignored their financial obligations to their military.  The Emperor became corrupt, handing out favors only to those closest to him and persecuting the opposition while ignoring the very real threats to the north until it was too late.  The Spanish also devalued their currency by reducing the precious metal content as they fought wars all over the world.  We all know how that turned out.  After WWI, the Deutschmark to the Dollar exchange rate was 4 to 1.  In order to pay their war reparations, the Weimar Republic started printing money.  A few short years later it was four million to one USD.  This destroyed the German economy and gave Hitler an opening to power. 

Today with convoys of Russian troops rolling through the Crimean Peninsula and Hind helicopter gunships controlling the skies, one doesn’t have to look far to see evidence of American weakness.  Whether or not you can understand the Russian position, the bottom line is that Putin does not fear a Western reaction to Russia projecting power in Ukraine.  This situation is the latest in a long list of examples of American economic weakness leading to serious national security threats.  Iran continuing to develop nuclear weapons, Syria defying the Russian brokered agreement to destroy its chemical weapons, Russia granting Snowden asylum, North Korea going nuclear, China threatening Japan, are a direct result of an absence of a serious American response or perceived threat.

Why is America no longer credible when our president draws a red line or two or three?  It is not just that Obama is a weak leader and naive in foreign affairs, although that is certainly true. It is because American owes $17 trillion dollars, a good chunk of  it to our adversaries.   It is because we are cutting the meat from our defense budget in order to fund bread and circuses to keep the people happy.  It is because pilots in the Air Force are flying the same tail numbers their grandfathers did.  The U.S. military used to train and equip to fight two wars simultaneously.  Now the world knows America is broke and cannot even sustain one long term conflict financially.  This status of affairs has not just happened under Obama.  A long list of Democratic and Republican administrations have not spent our money wisely.  And our allies in Europe are in no better shape.  In fact, their defense situation is worse after decades of relying on the Americans and running up their debt to GDP ratio as well. 

At some point, the FED will lose control of the bond market no matter how much money they print.  Then interest rates will be set based on the credit risk of the United States.  This will cause interest rates to shoot higher.  Each percent rise in interest rates is approximately $200 billion in increased debt service costs for the United States.  Soon the majority of the federal budget will go to paying interest and entitlements and defense will be squeezed even harder.  We have not even begun to see austerity yet.  This interest rate shock will also hurt the economy.  Do you remember the twenty percent mortgage rates in the seventies?  Federal revenue will shrink at the same time expenses are rising.  The future is not pretty.

America only has a short time to deal with this problem.  We need to stop spending money we don’t have and we need to grow the economy.  The government needs to get out the way.  If you are in a hole and want to get out the first thing you need to do is stop digging.

It is not our generation that will suffer.  It will be your children and grandchildren.  Do you hear that commotion to the north?  The barbarians are coming.

The Hydraulic Fracturing of Saudi Arabia

Since the early twentieth century, Saudi Arabia has had a close relationship with the United States. From the development of the Saudi oil fields, to the First Gulf War, this relationship has been an uneasy cooperation—each side received something out of the alliance while nervously watching the other. 

So now we have the first open break between the two powers culminating in the Saudi’s refusing a seat on the U.N Security Council due to anger with U.S. Middle Eastern policies. 

Saudi Arabia holds the world’s second largest oil reserves and the sixth largest natural gas fields.  In addition to being located in the most volatile part of the world, these energy assets make the country a strategic interest for any global power. 

The discovery of vast hydrocarbon reserves in the United States and the ability to harvest them through hydraulic fracturing techniques has radically altered the relationship between the two countries.  Ironically, even though the Obama administration has reduced drilling on Federal lands in the US and attempted to curtail hydrocarbon use overall, it is fracking which has allowed the United States to nearly gain energy independence, become a net energy exporter again, and reduced our need to buy oil from the Middle East.  This shift in the balance of power with the Saudis has made the Kingdom extremely nervous. 

American policy adds to the Saudi’s concerns.  Their oil fields, located in the eastern part of the country, are the home to the country’s Shia minority.  As the guardians of the holy Muslim sites, the royal family walks a fine line between satisfying the Sunni Ulema, fighting terrorism, and keeping the Shia population in check.  Hence, their concern with America’s recent overtures to Iran. 

The Obama administration seems Hell bent to secure a deal with the Shia Islamist state regarding its development of nuclear weapons.  The Saudis, along with the Israelis and other Gulf states, cannot tolerate a nuclear armed Iran.  There are rumors that Saudi Arabia has paid Pakistan for the development of its own nuclear deterrent and is one month away from operational capability if they saw fit. 

In addition, they are furious with the U.S. refusal to arm Sunni rebels fighting the Iranian backed Syrian regime.  The uneasy trust between the U.S. and Saudi Arabia has been broken.  This opens up the playing field for other global powers such a China or Russia to make inroads where the U.S. once enjoyed hegemony.  It also opens up the world to a possible nuclear arms race in the Middle East.  In fact, this is already happening in Egypt, another broken U.S. relationship, who just closed a major arms deal with Russia in a slap in the face to the Obama Administration’s decision to cut military aid.  China would like nothing better than to gain access to a secure source of Saudi oil and strategic American built bases as well.

There have been calls from many quarters for the U.S. to mend fences with Iran in order prevent conflict and counter the Sunni influence in the region.  It seems obvious that for this to happen, Iran needs to show real progress in addressing the world’s fear that they intend on acquiring the bomb and have plans to use this threat to destroy Israel and/or the interests of the United States. 

It is foolish for America to offend and promote distrust with another ally in a long list of broken long-standing relationships.  These include Poland, United Kingdom, Israel, Egypt, etc.  One wonders whether the results of American diplomacy  stems from extreme incompetence or is evidence of a much darker agenda.

Are We Fighting the Last War?

After World War I, the French built the Maginot Line on Germany’s border to guard against, and repel any German Army incursion into the homeland. Unfortunately for the French, they prepared for the defensive trench warfare that characterized WWI, and were caught flatfooted by the Blitzkrieg tactics of the new German Army, and were subsequently overrun in a matter of days by the powerful mobile army.

As an Air Force Academy grad, it was drilled into me during PMT or Professional Military Studies—that historically militaries fight the last war.  In other words, they train and equip to fight the last conflict they were involved in, while overlooking threats on the horizon—it’s a familiar, natural impulse.  And it’s troublesome.  The US military is on a path of committing this strategic error.

Since 9/11 the United States has fought two low-intensity conflicts.  Special operations forces have been front and center.  It is a vital and necessary part of our defense structure to be able to respond to unconventional threats in an unconventional manner.   

However, it is likely that the next conflict could be global and conventional in nature.  We are not prepared for this scenario.

The majority of our current bomber force started production in 1952, hence the B-52 designation.  We are still flying the H model, which was the last variant of 744 bombers produced and was fielded in 1962.  Yes, it has been modified and modernized, but the airframe is absolutely ancient by military standards.  The Air Force has about 20 B-2s, which cost about a $1 billion each, and are designed with decades old stealth technology.  The approximately 60 B-1s still in service were cancelled by Jimmy Carter and resurrected under Reagan’s defense build-up.  They also rely on an obsolete design.  The youngest of the crowd is the B-2 and even that is over twenty years old.  We have pilots flying the same tail numbers their grandfathers did. 

The fundamental purpose of air power is to precisely deliver ordinance on a target in a devastatingly effective way.  That’s what bombers do.  In a drawn-out global conflict with reasonable estimates of attrition, these one hundred and eighty aircraft are in danger of being decimated in a period of weeks or months.  Even small, rogue nations today have state of the art anti-aircraft technology, which could potentially wipe out our bomber capabilities and advantage. 

So let’s turn to the Navy.  Currently, the US Navy has less than three hundred combat ships.  Yes, these vessels can do the job that required multiple ships in the past and they are very powerful, but they are still only three hundred ships.  In asymmetric warfare, the enemy will employ tactics to use this concentration of power in a small number of ships against us.  Our adversaries, such as China, have developed very capable anti-ship missiles.  We can defend ourselves against the missile threat up to a certain point through advanced technology.  However, they can destroy our ships if they have enough of them.  And they can do it at a much cheaper cost than building a blue water fleet of their own.

As for our land forces, we are currently in the middle of a force reduction of approximately eighty thousand soldiers for the U.S. Army and around twenty thousand for the Marines.  There are additional cuts to come due to sequester.  The United States gave up several years ago the capability to fight and win two conflicts at once around the globe.  Soon, we simply will not have a large enough force structure to fight one.

Yes we have the greatest military in the world.  And it is true that no one can challenge our Air Force or Navy in the sky or on the seas.  That is, not yet. 

The fiscal pressures our country faces have brought about this diminution in military capability.  There is no end in sight to the reduction in expenditures for the Pentagon.  Of course there is waste to be cut in the Department of Defense.  However, we have to be careful not to impede the modernization of our conventional forces.  The United States also has to be careful to not allow hyper expensive weapon systems pushed by industry to crowd out the procurement of less expensive, capable, survivable armaments in larger numbers.  We are dangerously close to being unable to sustain a large scale, drawn out, global conflict.

The best war is the one not fought.  If our potential military adversaries perceive us as weak, that is an invitation to war.  If we continue to de-emphasize our conventional forces, we will invite this disaster.

The Long Term Issue is Solvency…

Originally posted at NewsMax Money News

After watching with intense interest the drama in Washington unfold over the last couple weeks, I am amazed at one simple fact. If you were an alien landing in America two weeks ago, you would be under the impression that the only issue is one party threatening to default on our debt if they don’t get what they want.

What I find shocking, absolutely shocking, is that NO ONE in the national press has been discussing the real issue — the approaching insolvency of the United States of America.

Our deficit is still obscenely large, the Federal Reserve has blown out its balance sheet to keep rates artificially low, and Obamacare costs have not hit yet.

If interest rates rise, even only a small amount, the insolvency of this nation will be revealed. Looking out into the future a couple decades, we will be $40 trillion in debt. We won’t be able to service it. That’s when the real default will happen.

No matter what your feelings are on Obamacare, everyone knows it will raise our required expenditures by a large amount. You can’t have millions of people added to the entitlement system and expect expenses will be lowered. That just doesn’t make sense.

Entitlement reform is a must because entitlements are the drivers of our mounting debt.

I won’t suggest a motivation for the lack of focus on the real issue, but if anything positive can come out of this recent fiscal tumult, let us hope it is a real national discussion in the media about American long-term solvency.

If we don’t deal with this, at some point Atlas (read bond market) will shrug.

Interest Rates are Low — Until They’re Not…

Originally posted at Newsmax Money News

So the market was shocked when the Fed decided recently to maintain its quantitative easing which is currently the life blood of the U.S. economy.  The ten year note passed back under 3 percent.  Many see the Fed’s decision on starting to taper as the driving force for interest rates going forward.  Certainly the Fed will play a major role on where rates are going; however, the threat of an external event that sends rates higher is very real. 

We are approaching $20 trillion in debt on our way to $30 trillion.  The Fed’s balance sheet has grown to almost $4 trillion via various rounds of QE.  We haven’t even seen the negative fiscal effects of Obamacare yet.  The USD is losing its reserve currency status.  Who knows what will cause rates to jump?  It could be a statement or action from one of our foreign creditors, an international incident, or a worsening of the debt crisis in Europe.  My point is we won’t see it coming. 

I think the real reason the Fed didn’t start to taper is they can’t afford to.  They know that each percent rise in the yield curve equates to $160 billion in debt service costs.  This will starve the rest of the federal budget; we don’t have the money!  They have been hoping for a robust economy to help pay down the debt, but alas, this is nowhere in sight.  The Fed can’t grow its balance sheet forever to control the bond market.

The bond market is in a position similar to the NASDAQ at the turn of the century.  Everyone knows it’s way overvalued but continues to play along.  Interest rates only go from twenty percent to zero once in a lifetime.

As Sam Elliot so famously said in the movie, We Were Soldiers, “Gentlemen, prepare to defend yourselves!”

Book Review from The Bankers Umbrella of Currency

 
We all love a good story right? Something that we can just shut off the “effort” part of the brain, flick on the autopilot and dive into an exciting fast paced book that allows us to escape from the day-to-day.

The thriller; Currency by L. Todd Wood is just such a story. It ticks all the right boxes: Troubled handsome main character, check. Multiple glamorous locations, check. Hot chick character, check. Another hot chick character, check. Baddies with guns, check. Secret operatives with bigger guns, check. Troubled handsome main character getting up close and naked with hot chick character, check. I don’t want to spoil the plot too much so I’ll leave the box checking there. I think you get the idea though. The book has this, that and a bit of the other and all in a good balance.

The thing is, there’s a little bit more than the box checking, two things in fact: First. The clue is in the name: Currency. The plot evolves around the financial world and what L. Todd Wood has done a brilliant job of is explaining the world of finance by interweaving it in to a fast paced thriller. Wood has a strong background in finance and it shows, but there isn’t a trace of the all too common boring explanations of finance.

If telling a story is the greatest way to teach, then Wood does a blinder of a job. While reading the book I couldn’t help but think that this is a book I would give to someone who knows nothing about the financial world as a covert way of teaching them how it actually works. They’ll enjoy the page turning thriller, but once the book is set down and they watch the financial news on CNN, they’ll say “Wow, what happened? I understand what these talking heads are talking about”


People pay thousands for an education like that. You get it for USD 5.99 on a Kindle. How is that not a great deal?

Secondly. There are multiple historical timeframes in the book. This is exciting stuff. The book moves from timeframe to timeframe and back without confusing the reader. Wood’s attention to historic detail is evident and what man doesn’t like a good pirate story?

For those of you who are versed in the world of finance I recommend it to you, since you’ll relate to a lot of the issues raised in the book. For those wanting a good thriller from an author we are sure to hear about more, I recommend it for the exciting page turning story and the free education.

Buy the Kindle version for yourself here, and as a present to family or friends here.

America will Default…

No matter what your political persuasion, we are approaching the tipping point for our country regarding our ability to service our sovereign debt.  The unfunded mandates of Obamacare, Medicare, and Social Security are unsustainable.  These entitlements are the real drivers of insolvency.  We need to make a choice as a country now—not in ten years—whether or not we want to maintain our way of life and our security.  The question you should ask yourself is, “Do I love my children enough to fix these problems?”  They are the ones who will suffer.

CFTC Goes Global…

Originally posted at AffluentInvestor.com

 

Three years after Dodd-Frank came alive, the U.S. Commodity Futures Trading Commission was set to enforce its cross border derivatives rules on July 12th, 2013.  The CFTC has primary responsibility for overseas derivative trades (a small slice is reserved for the SEC) and has aggressively taken up the challenge to prevent another systemic financial crisis here in the U.S.

Many U.S. banks, hedge funds, and other financial institutions have entities established offshore ostensibly to get around the U.S. regulatory and tax regime.  Many of the players pushing for this reform are happy to point out all of AIG’s trades that brought down the company were booked in London.  Until recently, Gary Gensler, CFTC Chairman, had resisted calls for further delay in the proposed rule implementation.  A meeting last week with Treasury Secretary Lew seems to have altered his thinking.

What the new set of rules basically do is extend harsh new American regulations to any trade that involves a “U.S. person,” which includes entities substantially owned by Americans or primarily based in the U.S.  So your hedge fund based in Cayman that is owned by an American will be covered.  

The reasoning behind the new rules is to prevent the scenario of firms booking trades overseas in more friendly regulatory environments and having the consequences still flow back to the the U.S. financial system.  According to the CFTC, if there is no cross border, there no reform. 

The regulatory push has angered overseas officials, especially in Europe.  It goes without saying that foreign governments are loath to be lectured on financial regulation by the United States given our recent history.  There are also concerns that these rules will drive business away from American institutions to countries where the cost of following the rules is not so high.  There is a substantive compliance rule in the new regulatory regime by the CFTC which allows for U.S. institutions to be governed by a foreign regulatory environment if they are building a framework similar to Dodd-Frank.  This effectively gives foreign banks an advantage in compliance costs, albeit temporary. 

How these changes will finally be implemented is unclear.  Much depends on how foreign markets develop their own rules.  Will they be put in place in a timely manner?  Will they be sufficiently rigorous to satisfy American regulators? The bottom line is that you have another year to prepare for cross border derivative regulation but there is a big question mark as to how this compromise will finally be enforced.  If you are involved in the cross border swap market, it is critical you pay attention to regulatory efforts in countries where you frequently trade.  


How will it affect U.S. banks?  Primarily, the result will be higher costs to the industry.  If there is a prolonged advantage given to foreign banks, U.S. banks could lose market share.  There could be a hit to earnings as swaps are a high margin business.  The upside will be that if you put on a swap trade with a U.S. bank, you’ll be able to sleep better at night, compared to less regulated jurisdictions.