Australian Equities: Covering your options in down markets

For most market participants, 2008 was one of the most challenging years ever experienced.

As we move through 2009, many investors are debating the outlook; will the market disappoint as it did in 2008, will it stabilise or indeed recover in 2009? Will volatility remain and what are some of the themes expected to impact investors?

Current and expected equity market valuations are providing a reasonable backdrop for an equity market stabilisation in 2009. The ASX 200 index looks like reasonable value, according to a range of traditional valuation metrics. The forward-looking consensus price to earnings (PE) ratio is currently close to 10x.

As earnings season unfolds, we have seen further earnings downgrades and can expect this trend to continue in the first half.

Notwithstanding further earnings downgrades, we still believe the market represents reasonable value. In many instances, earnings have been significantly rebased providing greater potential for an improvement in company earnings in future years.

However, despite the apparent value within equities, the credit markets still remain the major swing factor in determining the outlook for equities in 2009.

To date, we have seen significant government and central bank responses to the credit markets that are attempting to thaw out the credit conditions.

Until we see credit markets moving towards more normal conditions, uncertainty and high volatility will remain part of the equity market landscape.

Volatility has been a running theme in investments markets since November 2007, with levels currently sitting at more than two times the long run average and four times greater than the level experienced during the bull market conditions seen between 2004 and the majority of 2007. We expect volatility will remain for some time yet to come.

Many companies are finding their balance sheets under pressure and are being forced to respond.

A large number of companies are tapping the equity market to raise cash, and there is a growing trend of reducing dividend payouts to shareholders in order to pay down debt.

This is causing an additional risk for those investors who rely on dividends for income. This year may well turn out to be the year of the dividend cut.

With a question mark rapidly appearing over dividend payments, this has the potential to cause many investors to look elsewhere for the income their portfolios require.

This market volatility certainly presents a number of challenges for investors, and those whose role it is to advise them, and can create a great deal of nervousness when trying to time a re-entry into an investment market that is starting to show apparent value.

At the same time, cash and fixed interest are trending lower, meaning that even conservative investors are looking for alternative sources of consistent income.

Some other high yield equity investments, such as financial and property securities, are carrying inherent capital risk and this, along with the potential for dividend cuts in 2009, could create further shortfalls when it comes to income.

However, within all of this volatility, some opportunities and equity-based alternatives to high yield stock can still exist, even for those with a more conservative risk appetite.

These opportunities can incorporate both consistent income and a managed level of risk even in these uncertain times.

In my view, one of these opportunities is to use covered call options as a strategy to limit exposure to the equity market, while bringing in a consistent source of income for the investor’s portfolio.

Volatility has always been part and parcel of the markets and it can be harvested to generate income, as explained in more detail below.

By writing call options over shares, investors can potentially receive upfront income, which may provide some cushion in down markets and offset any income drought.

In most down markets, volatility tends to increase significantly, as illustrated during the recent market correction. Generally, the more volatile the market the higher the option price. Hence, when you sell a call option, you may receive additional upfront income potentially providing some cushion to the portfolio during difficult market conditions.

Further, having the options exposure also means investors do not necessarily need to lean towards high yield stocks, meaning a more diversified and defensive portfolio can be sought.

As such, in a diversified portfolio of stocks, the potential to sell covered call options over your holdings can be significant. For those advisers who are not traditionally active managers of options strategies for clients — and not all are — funds do exist that apply this investment style.

There are indications that this style of investment, while mature in the US and European markets, is starting to gain traction in Australia, particularly as more investors here seek income from diversified sources and the recent increase in volatility in the financial and property sectors.

The investment strategy may be suitable for investors who are looking for potentially lower volatility than a traditional equity market (such as the S&P/ASX 200 Index) and have a strong preference for regular income paying investments.

What 2009 has in store for us no one can accurately predict, but the encouraging sign for advisers is that opportunities are emerging and these can be presented to investors who are looking for income, even when times are far from what we all might consider to be normal.

Bruce Apted is a senior portfolio manager at Macquarie Funds Group.