How Inflation Worries Could Lead To Actual Inflation…
Inflation is garnering attention, as it should. Last week, the Consumer Price Index reached a 13-year high. This week, the Producer Price Index reached all-time highs.
Inflation is one of those factors that isn’t a problem until it’s a problem. By that I mean inflation remains relatively low and then rises sharply. We saw this in the 1960s and 1970s.
Source: Federal Reserve
The reason for this pattern is consumer expectations of inflation. As The Wall Street Journal recently noted, “The inflation effect of supply shocks is transitory so long as the public doesn’t expect permanently higher future inflation. Higher expectations can change wage and price-setting behavior and thus become self-fulfilling.”
Prior to the late 1960s, inflation had largely been associated with war. But the Vietnam War was different than historic wars. It wasn’t the full mobilization of the previous World Wars. Without any historical precedent, consumers were vulnerable to panic.
Once inflation jumped above 5% in 1970, consumers became worried. Dips in inflation were followed by oil crises. This drove consumers to spend as they worried prices would rise again. Their behavior drove the price inflation that defined the 1970s.
The Expectations Game
Maybe this time will be different, but consumers are already showing they’re worried.
According to the latest data from the Federal Reserve Bank of New York’s Survey of Consumer Expectations, median year-ahead inflation expectations increased to 4.0% in May. This is the seventh consecutive monthly increase and a new high in the data.
Source: Federal Reserve Bank of New York
Not surprisingly, given their experience in the 1970s, older consumers are more concerned about inflation.
Source: Federal Reserve Bank of New York
Consumers with less education are even more concerned.
Source: Federal Reserve Bank of New York
This also makes sense. Those with college degrees are often in higher-paying jobs and own their own homes. Their mortgages insulate them from rent increases, which are becoming more common. The more highly educated households also generally spend less of their income on daily necessities in percentage terms. They see the impact of inflation later than those without a college degree, and those without a degree comprise the majority of Americans.
The reason I bring this up is pretty simple. Right now, many of our policymakers are assuring us that the current signs of inflation we’re seeing is “transitory” in nature. In other words, it will all go away soon. But if inflation expectations are high for the majority of consumers, then this could become a self-fulfilling prophecy and become a source of future inflation.
How I’m Trading Right Now (Plus 3 Useful Tips)
How the Federal Reserve responds to these expectations will determine the fate of the bull market. I’ll be keeping a close eye on these developments, of course. And as has been the case for the past several weeks, I’m remaining conservative with my approach by recommending trades with a large margin of safety.
One of the best ways to do this is with covered calls. For those who aren’t aware, a covered call strategy requires you to sell call options on a stock you just bought or already own.
When you sell a call, you generate instant income, also known as a premium, upfront. Since you own the stock, you participate in the upside of the stock and the income can offset some of the downside risk. But only if you do it right…
Now, I realize some of you may already know how this strategy works — even if you aren’t a member of my premium service, Maximum Income. So I thought it might be useful to offer some tips for writing covered calls in a safe, effective manner that will also allow you to enjoy the income-generating benefits of the strategy…
1. You should only write covered calls on stocks you want to own. Never chase big premium in risky stocks. Big premiums may be tempting, like a stock yielding 15%, but can lead to losses that would take years to recover from. In other words, only sell covered calls on stocks you don’t mind owning for the long-term.
2. Determine the price you are willing to sell that stock for. Make this your line in the sand for the profit you’d be happy to walk away with — rather than an arbitrary point you use to chase premium.
3. Sell the option with the least time to expiration that offers a reasonable return. I target a return of at least 15% to 20% annualized, assuming the option expires worthless. Calculate the return by dividing the premium by the strike price, then annualize the return.
Closing Thoughts
Selling call options can be part of a conservative or aggressive portfolio. It can also be used as a stock selling strategy to ensure that you sell when stocks hit their target price. Best of all, it puts you in command of how much income you receive from your holdings, even if the stocks don’t pay a regular dividend.
In a lot of ways, selling covered calls works like an “insurance policy” on your portfolio. It’s one of the most effective ways to hedge risk — while making a substantial amount of income in the process.