The Wealth Effect

Here is another great and timely article from James Cordier of Option Sellers. He always provokes us to think and this time is no different. Thought it might be great reading for a Sunday evening. Hopefully it will help keep things in perspective.

“I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out” – Warren Buffett

Recently the stock market has been roaring to new all-time highs, and at the end of the month most of you are going to open up your quarterly statement to see your equity portfolio with some nice returns for the 1st quarter of 2013. The average investor will see this as an increase in their wealth and an opportunity to invest in something new or possibly splurge on that new boat they always wanted.

Life must be good right? Not so fast!

Frequently referred to as the “wealth effect,” the increase in the market value of an investors’ portfolio stimulates a feeling of being wealthier and often leads the investor to spend rather than save. This is what the Fed was banking on to help stimulate the economy and it appears to be working in its initial stages so far. It is okay for investors to engage into new investments or make new purchases based on gains in their portfolios, but only if they ask themselves one important question, “Is this perceived wealth or real wealth?”

Well the key to that question is inflation and unfortunately it is not a question of “if”, but “when”. I wish I could tell you when inflation will begin, but I do not have a crystal ball, for if I did, I would probably be sitting on an island somewhere. But what I can tell you is that, when the time comes, the Fed chief WILL be reluctant to raise interest rates to slow down inflation. Instead, we will continue to hear the same spiel that we have heard in the past, “inflation appears tame minus the volatile food and energy prices.”

How did we get here?

Well, we are now approaching 3 ½ years and trillions of dollars later since the Fed chairman introduced the US economy to quantitative easing and lowered the Fed funds rate to zero. As you probably now are aware, the Feds “game plan” was to stimulate the housing market and consumer spending by keeping interest rates at a minimum. Not only has this policy crushed the savers, but it has in essence held a gun to the head of investors and money managers forcing them to buy stocks; truly manufacturing wealth.

Today, central banks from all 4 corners of the earth have joined the money printing party, and the US is buying back $85 billion a month of mortgage backed securities to keep interest rates low. However, recently over the last couple of quarters, we have finally started to see the US economy shed some signs of light with the decrease in unemployment and improving housing numbers.

So is the United States really in recovery mode?

We think that the US economy is on the mend the new fashion way, inflating a new bubble. As the stock market continues to rally investors start to accumulate more wealth. The accumulation of wealth increases investors’ confidence to invest in assets such as the housing market. As the economy starts to strengthen it will then be in the Fed chairman’s hands to decide when to raise interest rates to control the threat of a spike in inflation. And by the way this is a Fed chairman who said he sees zero percent interest rates far into 2015. So as you can imagine, a rise in inflation will translate into an increase in prices of commodities such as sugar, crude, coffee, and grains, which in the end will translate into a higher gas bill for those new boat owners.

Today, as you know, the stock market is up, the housing market has started to indicate some strengthening, however you might not realize that raw commodities such as sugar and coffee are hovering near 32 month lows. This tells us that the commodity market has not felt the effects of inflation yet, and provides a good opportunity for investors to diversify/protect their portfolios against it. We understand how it can be difficult to invest in a market that is downplayed by the media and where bullish bets from hedge funds are at 4 year lows. Yet, we both know that the top investors like Warren Buffett lick their chops when they see markets or companies that have been beaten down.

When inflation starts to hit the US economy the Fed chief will continue to downplay the inflation numbers and WILL NOT raise interest rates to counteract for the rise in inflation. Investors who were able to realize this beforehand and diversify their portfolios accordingly will continue to enjoy the sun riding around in their new boat, while others will be stuck at the dock with an empty lift wondering what they could have done differently.

With commodity prices trading in a sideways to lower trend over the last several months selling strangles has worked extremely well. However, it may very well be just a matter of time that price trends begin to change offering what we think will be great opportunities over the coming several quarters. Ultimately this could create a great opportunity to sell deep out-of-the-money options to diversify your portfolio and perhaps give YOU the chance to shoot fish in a barrel with no water.

James Cordier is author of McGraw Hill’s The Complete Guide to Option Selling. He is also the founder of Liberty Trading Group/, an investment firm specializing in writing commodities options for high net-worth investors. Appearing regularly on CNBC, Bloomberg Television and Fox Business News, James’ market comments and research forecasts are published by most major financial publications including The Wall Street Journal, Reuters World News, Forbes, and Barron’s. For more information on managed option selling accounts visit