Wednesday, June 17, 2009

How to Make Money in Range-Bound Markets

MEYER CAPITAL MANAGEMENT

Independent Investment Advisers

SECOND

QUARTER REPORT

June 30, 2005


How to Make Money in Range-Bound Markets


As we all know, stock and bond prices move up and down over time. Persistent price movements in one direction or the other eventually develop into trends. Investors, of course, favor up trends and frown upon down trends.


There is a third price pattern however that is almost as common as the up & down price actions we are all familiar with. This is an essentially flat pattern that occurs when security prices fail to move decisively in either an up or down direction. Instead, they do little more than hover around the same level. We find ourselves in this situation today.


The major stock market averages, year-to-date, have bounced around a fair amount but, despite the volatility, remain within a few percentage points of where they began 2005. The trend is essentially flat. Be that as it may, investors remain interested in earning a positive return on their money even as stock and bond prices aren’t cooperating much. There are a number of alternatives available to combat flat market cycles.


1. Increase the income component of the portfolio. This is accomplished by shifting the asset allocation of the portfolio away from growth-oriented investments and toward income-producing securities like bonds and dividend-paying stocks. The interest and dividends earned on these types of securities is real cash paid to the portfolio regardless of what the prices of these securities are doing. We frequently hear this referred to as “getting paid while you wait.”


While this sounds good, there is a trade-off. The income generated comes at the expense of capital appreciation (i.e., growth). Consequently, when security prices do eventually break out of their trading range, assuming an upside move, the income-oriented portfolio will under perform. Therefore, investors must consider whether it is better to stick with the original asset allocation and simply wait out the doldrums or change the portfolio mix as described above.


2. Sell call options. A call option is simply the right to buy a share of stock at a fixed price at a fixed date in the future. A conservative way to sell call options is to sell them on stocks that you already own in your portfolio. These are called covered calls. Selling a covered call is a bet on your part that the share price will drop below a certain level at which the buyer of the call will decline his/her right to buy your stock. He/she already paid you real cash for the right to purchase your stock and now that right has expired. You retain your stock and keep the cash from the sale of the covered call. Successfully executing this strategy again & again can have a materially positive impact on portfolio performance.


As always, however, there is a trade-off. If the price of your stock rises instead of falling, the buyer of the covered call will exercise their right to buy your stock at a lower than market price. You lose your shares and forgo the incremental gain in the stock. Ouch!


3. Security Selection. You’ve probably heard the phrase, “This is a stock picker’s market.” This means that the markets overall aren’t doing much so investors have to pick their spots in order to achieve a positive rate-of-return. This is a research-intensive and time consuming approach.


Utilizing this approach in 2005, investors who over-weighted the energy (+18.84%), utility (+13.16%), and health care (+2.69%) sectors were rewarded. These are the only industrial sectors of the US economy that showed positive performance year-to-date. Interestingly, focusing on just the 12 weeks that comprise the second quarter is also revealing. Utilities (+8.35%) and healthcare (+3.75%) did well again. But financials (+3.65%), telecommunications services (+2.64%) and information technology (+1.60%) all delivered positive performance and surpassed the energy sector (+1.52%). By not owning these newcomers, investors would have hurt their portfolio performance in the second quarter.


So what’s the best solution? Meyer Capital Management uses a combination of all three of the techniques discussed above. Prevailing market conditions and individual client objectives dictate how and to what extent we implement each method. As each client is different, each investment portfolio is also different. Utilizing a case-by-case approach enables us to customize our methods to meet individual circumstances.


How good are the results? Fully, two-thirds of the MCM-managed portfolios show positive, market-beating returns year-to-date. For the second quarter alone, that figure increases to almost ninety percent.


We hope you are having an enjoyable summer. As always, just let us know if there is any way that we can meet your needs better.


Timothy R. Meyer

President

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