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What The Failure Of Shiller’s CAPE Shows About Stock Picking

Summary Empirical models are validated based on predictive success, not backtesting. CAPE has been above average 98% of the time since introduction in 1988, and thus never worked. CAPE has failed because earnings have secularly risen since 1992. Capital deployed on corporate buybacks and acquisitions has hit record levels during this time. Capital spent on hiring and expansion increases competition and wages. Conversely, financial engineering favors restrained hiring and improved margins. When major technology companies are compared, it is often the efficiency of capital allocation that is more important than the initial strength of their moat. Above Average is the New Average The New York Times , Marketwatch , the Wall Street Journal , and some Seeking Alpha articles all periodically warn that, according to “the historical best predictor”, stocks are currently overvalued. To be sure, SA offers a diversity of viewpoints, whereas the NYT publishes any opinion which is Robert Shiller’s. This putative best predictor is, of course, Shiller’s Cyclically Adjusted Price/Earning (CAPE) ratio, namely the current price of the S&P 500 divided by a moving 10-year earnings average, adjusted for inflation. Mr. Shiller first advocated this measure in 1988 . The idea seems so sensible it has been widely embraced, despite frequent complaints that CAPE has recently broken down. CAPE has not broken down. It has never worked. Since it was introduced, CAPE has spent about 98% of the time above average . The situation is reminiscent of Garrison Keilor’s Lake Woebegon, “where all children are above average.” We now have close to three decades of reasonably strong stock gains, despite a nearly incessant prediction that stocks are overvalued. Even CAPE’s rare dip below “average” was hardly impressive: following the Great Recession crash, CAPE in 2009 briefly suggested that stocks were 15% undervalued. Gains since then have been about 20% (annualized, not a one-time rise). Proper Empirical Model Testing But doesn’t Shiller’s model still deserve to be called the best historical predictor, given the century or so of data leading up to the 1990s? No. An empirical model is constructed using one set of data (“construction set”), and tested using a new set of data (“test set”). An empirical model should not even be announced if it does not work on the data used to construct it. Shiller’s model was announced in 1988, and constructed using S&P 500 data up to that date. Valid testing is based on subsequent years. Since introduction, it has almost continuously warned that it was not a good time to be in stocks. Yet stock gains over the last quarter century have been quite satisfactory. Yes, CAPE was particularly high before the crash in 2000, but even the ordinary trailing-twelve-month P/E was above 40. One does not need binoculars to see a barn by daylight. With quibbling exceptions, CAPE has been stuck on sell since construction. Even a stopped clock will eventually be right. CAPE is Not High Because of Irrational Investors The theory has not failed because of irrational exuberance lasting more than two decades. Jeremy Siegel has argued that CAPE should be higher than the average imputed from older data because improvements in accounting standards have upgraded the quality of earnings. Whether that is really true or not (Mr. Shiller disagrees), it is not the reason CAPE has failed. The answer – at least the proximate answer – is straightforward. Earnings since 1992 have not been cyclical at all, as the graph below shows. They have secularly increased. (click to enlarge) In addition to the secular earnings uptrend since about 1992, one should note that the decrease in earnings during the 2008-2009 Great Recession can be compared only to the early 1920s. Using CAPE today means assuming that a once-in-a-century event will happen again soon. Incidentally, CAPE is not ideally constructed. Because only aggregate earnings are considered, a company can actually negatively contribute to the valuation of the whole S&P 500. If you own 9 stocks with positive earnings, and I give you one more with negative earnings, the value of your portfolio has not declined. CAPE ought to have been constructed with positive definite components. If that mathematical term is unfamiliar, it simply means no company should negatively contribute to the value of the index. The problem is not hypothetical, given AIG’s losses reached $61.7B in a single quarter in 2008. The uptrend since the early 1990s has been quite strong, as noted in a thoughtful post from Philosophical Economics : “Over the last two decades, the S&P 500 has seen very high real EPS growth-6% annualized from 1992 until today. For perspective, the average annual real EPS growth over the prior century, from 1871 to 1992, was only 1%.” If earnings are rising by 6% a year, then predicting future earnings by a trailing 10-year average does not work . Concrete Example: CAPE Prediction vs Reality A concrete example should help demonstrate that CAPE has been high not because investors have continuously overpaid (for a quarter century!), but because CAPE has been too pessimistic about profits. The CAPE debate has been going on long enough to provide this handy example from four years ago : … CAPE was reported as 23.35 during the month of July 2011 on the Irrational Exuberance website ( irrationalexuberance.com ). Per an analysis frequently used in practice, comparing the July 2011 CAPE to its long-term average of 16.41 indicates that U.S. stocks are currently overvalued by 42.3%. In contrast, on July 22, 2011, Standard & Poor ‘ s reported a price-earnings ratio of 16.17. Using round numbers, stocks had a 100% gain over the 4 years since that warning, only about a quarter of which was P/E inflation. CAPE has almost continuously under-predicted future profits since its introduction. Why the Secular Rise in Earnings? Profit margins have surged to a record 10% of GDP, from historical values of about half that. One does not have to look too hard to discover what companies have been doing differently. When companies have excess capital, they can (1) invest in developing new products, (2) expand existing operations, or (3) buy stock, either their own or acquiring another company. In other words, they can increase competition, or engage in “financial engineering.” It is no secret that share buybacks have hit record levels, actually accounting for the majority of the total cash flow for S&P 500 companies. That is unprecedented. Mergers and acquisitions are also going briskly, with the WSJ reporting September 17 that $3.2 trillion has been spent so far this year (the number is worldwide, but the U.S. still certainly participating full heartedly in this orgy). Note that the Shiller CAPE method does capture the direct effect of share buybacks on increasing earnings. The “P” is market cap, and the share buybacks increase earnings per share, but do not change total company earnings (or, necessarily, total market cap). However, financial engineering has salutary secondary effects not captured by CAPE. Consider the case of Apple (NASDAQ: AAPL ) toward the end of the Jobs era, when Apple was sitting on $100B in cash. Steve Jobs asked Warren Buffett what should be done with the money. Mr. Buffett suggested share buybacks. This answer did not satisfy Mr. Jobs, but it has worked for Tim Cook, and Apple shareholders. Suppose that instead Apple had decided to introduce its own television (as Gene Munster incorrectly insisted), sell its own car, design its own CPU for notebooks and desktops, and perhaps even do its own fabrication of processors, instead of paying Samsung ( OTC:SSNLF ). One hundred billion is enough to do all these things at once. Each of these would have required new hiring, and building new plants. All that hiring would have tended to drive up wages. Also, the increased competition would have driven down prices, or at least had a tendency in that direction. In short, when companies buy back stock, or better yet, buy each other, instead of spending the money to increase competition, wages are kept down, and profit margins are higher. Who Benefits? While companies have spent preferentially to reduce competition (acquisitions), or by buying their own stock, rather than by hiring people to expand operations, wages have not kept up with economic growth. In fact, while corporate profits hit a record percentage, wages have increased only slowly since the end of the Great Recession. For someone hoping to be hired, or anyone wishing that another company would bid up his salary, financial engineering might not seem quite so salutary. From the viewpoint of shareholders, the recent fiscal discipline of companies such as Apple is commendable. Any specific product from any specific company might be a better idea than share buybacks. But for the market in the aggregate, less competition, lower wages, and higher profit margins have been a winning formula. Capital Allocation Some company CEOs are empire builders, others prize efficiency. Efficient allocation of capital can cause some investors’ eyes to glaze, whereas heavy spending on long shots can be inspirational. It is surprising how many people I’ve encountered, who are more likely to buy Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) because it is working on driverless cars, investigating quantum computing, and frittering away money needlessly indulging the founder’s whims. Conversely, Wall Street money managers take capital allocation quite seriously. The enormous surge Google had in the hours after its July earnings report had little to do with the actual mediocre results and a great deal to do with hints that the recently hired CFO, Ruth Porat, was going to bring much-needed efficient use of capital to the company. Anticipating a Counter Example Microsoft (NASDAQ: MSFT ) pays dividends and buys back shares. Amazon (NASDAQ: AMZN ) spends everything it earns from its retail operations to compete in new areas. It also has been hiring robustly to do so. Doesn’t this show that financial engineering doesn’t work? Hardly. MSFT practiced laughably poor capital allocation for at least two decades. Say the words “serial overpayer” to a market aficionado and she will likely take you to mean MSFT. MSFT also tried to emulate the great laboratories of the past (such as Bell Labs of the old AT&T (NYSE: T ), or what Xerox (NYSE: XRX ) had), hiring notable academics for long-range research. And MSFT has spent tens of billions trying in vain to compete with Google in search and Apple in phones. Amazon gave the last one a go as well. But when the Fire Phone failed, it didn’t spend another $7.2B to buy a fading phone designer. Amazon just laid off the associated workers from its Lab 126. The company is not worried about this quarter’s numbers, but the company is nonetheless very results-oriented. Bezos was a hedge fund manager before founding Amazon, and his keen interest in careful capital allocation manifests in many ways, including not overspending on employee benefits, and the practicality of the projects Amazon attempts. Admittedly, a stock buyback is rarely the absolute best possible use of money. It is, however, typically better than the empire building most CEOs attempt. Summary Part 1: So, Is The Market Overvalued? One generally can do well by simply looking at ordinary (meaning TTM) P/E, and whether that has been rising or falling. The current P/E is 20 and, alas, trailing-twelve-month earnings have been falling for about a year. Forward analyst estimates are meaningless, as documented in excruciating detail in Burton Markiel’s A Random Walk Down Wall Street . So, yes, stocks are overvalued, but by about 15-20%, versus the 40% plus suggested by the current CAPE (= 25). Believing in CAPE requires believing a once-in-a-century profit recession is imminent, and that corporations are soon going to abjure financial engineering and start more aggressive expansions – plausible, but hardly certain. Summary Part 2: Capital Allocation In The Aggregate For the market as a whole, the current large portion of corporate free cash flow spent on share buybacks and acquisitions has restrained hiring and thus wage pressure, while reducing competition. This has steadily improved net profit margins, and raised corporate profits to a record 10% of GDP. This phenomenon largely explains why profits have not been cyclic, but secularly rising. Summary Part 3: Capital Allocation In Stock Picking For the very long-term investor seeking to exploit the tax advantages of unrealized gains, capital allocation is crucial. Indeed, because of compounding, capital allocation will eventually win out. If a company fritters away its earnings, even a business as great as Microsoft’s can struggle to provide adequate returns. Conversely, if a company returns money to shareholders, and carefully monitors whether its projects are producing worthwhile results, long-term performance will be superior. Disclosure: I am/we are long AMZN. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Generation Portfolio: Wells Fargo, Disney, MFA Financial, Bristol-Myers Squibb

Summary Last week provided some good buying opportunities, but they became fewer as the week went along. I used the market volatility to add Disney, Wells Fargo, Bristol-Myers Squibb, and MFA Financial to the Generation Fund. The next two weeks are likely to provide more buying opportunities as the markets strive for clarity from the Fed about the timing of the first rate hike. As I explained at some length in my recent article ” The Generation Portfolio ,” I am managing a portfolio of stocks in which I do not have a personal interest for another party. The goal of the portfolio is to create a low-risk income generating machine populated with a core of Quality Stock plays. I began the portfolio from scratch during the week of 24 August 2015, though it had a large legacy position of Ford Motor Company (NYSE: F ) stock that is untouchable. I will use these updates to show what I have done with the positions and give my general strategy and thoughts on the market. Market Summary The week of 24 August 2015 was volatile. The Friday before, the market sold off heavily, and anxiety built up during the weekend. Monday morning saw a “flash crash” in which stocks and other securities either opened late or opened with unusual drops in price. However, those prices easily were the lows of the entire week. The next several days were extremely volatile, with the market rallying into a status quo Friday. For the week, the market was up slightly, but overall the market remains well off its highs. Long-Range Objective for the Generation Fund I intend to form a hard core of at least 50%-75% Quality Stocks, and around that orbit a number of more speculative REITs and other plays for cash flow. This objective is subject to tweaking. Transactions I was unable to log in first thing Monday morning, like many other traders. Once I got in, the market was too volatile for me to get a good read, so I placed no trades that day. On Tuesday afternoon, the market seemed to be providing some more good opportunities. I placed four limit orders and picked up average-sized positions (as discussed in my previous article) in the following: Wells Fargo (NYSE: WFC ) Disney (NYSE: DIS ) MFA Financial (NYSE: MFA ) Bristol-Myers Squibb Co (NYSE: BMY ) Those positions remain in the account and, including the Ford stock, are the only positions I am tracking here (there also are some other minor legacy positions). Those positions constitute roughly 10% of the entire tradeable funds as of the time of writing, the rest of the Generation Portfolio remains in cash. Analysis of Trades Due to the subsequent market rally on Wednesday and Thursday, all new positions in the Generation Portfolio show a profit. Basically, with few exceptions, the market lifted all boats on those days. This simply illustrates that timing is the most important part of trading, and you don’t need to be much of a stock picker if you can ride the general market waves higher. I placed all the trades on Tuesday, using limit orders. With a few hours left in the trading day I staggered the limit price distance from then-current prices, not expecting to pick up all four unless there was a major sell-off in the final hour of trading. So, one order was roughly .25% below the current price of the stock, the other .50% below, and so forth. Normally, those types of orders would not hit due to lack of volatility. As it turned out, a major sell program hit an hour before the close of trading, and – to my surprise – all four limit orders hit, the final one a limit order I had set a full 1% below the market price at the time, were filled. Reasons for Picking Up Those Stocks Basically, as events subsequently transpired, I could have bought practically anything when I did and the rising market would have turned them into quick winners. I consider BMY, DIS and WFC to be “Quality Stocks” as I have defined that term in my recent article linked above, and all were down substantially from their highs when I placed my limit orders. As for MFA, I recently wrote about that mortgage REIT here . It has been around as long as Annaly (NYSE: NLY ), surviving numerous Fed actions, giving me confidence in its survivability come what may. It also appeared to be heavily oversold on the chart, more so than the other REITs I am interested in. Quality of the Trades Overall, it was a successful week. My intention was to go slower than turned out to be the case in populating the Generation Portfolio, spreading it out over time more with maybe one transaction a week, but the opportunities proved irresistible. As the old military aphorism goes, no plan survives contact with the enemy. Regrets were entirely along the line of missed opportunities. I intended to pick up some Apple (NASDAQ: AAPL ), but never found a comfort zone with it. Most of the huge bargains that some traders were bragging about during the happened only during the first half hour of trading, when I was off-line. Still, I should have grabbed some, and that is the main regret for the week. Overall, only buying 10% of the Generation Portfolio’s tradeable value (less the Ford position) during a week of such bargains may seem like a missed opportunity. Perhaps it was, but I anticipate further volatility ahead, as discussed below. If not, there is nothing wrong with waiting. The Week Ahead The market likely is to be preoccupied throughout the week of 31 August with the August employment numbers that are due out on Friday. The importance of that report was heightened by an interview given on Friday 28 August to CNBC by Fed Vice Chair Stanley Fischer, and other remarks that he made on Saturday . While, as one would expect, Fischer was cagey about the likelihood of a September rate hike, one thing that he said during his CNBC interview stood out. When asked about the importance of data between the time of the interview and the Fed meeting on 15/16 September in influencing a rate hike at that meeting, Fischer said: Well, we’ve got to take data into account. Those are the only things we really have, that and our economic analysis. And if a decision is close, it will be influenced by data that [have] come in recently. Pretty much everybody expects the decision to be “close.” Since the Fed has not made a decision about rates, and Fischer stated that the data leading into the data could be decisive, that puts immense influence on the Friday jobs report. Given that statement by vice chair Fischer, I would not be surprised by some volatility both ahead of the report and immediately after its release. The consensus figure for the September 2015 jobs report is 223k jobs added, up from the 215k figure reported in August. The market easily could interpret anything above 190k jobs added as locking in Fed action. The other major market-moving event in September, aside from the Fed meeting itself, could be the government deadline for raising the debt ceiling. The Congressional Budget Office projects the debt ceiling being hit either in mid-November or December. With several US Senators running for President, Presidential politics could enter the Calculus and cause some posturing that rattles the market as has happened before. One other major factor is the statistical fact that, historically, September is the worst month for stock gains. Combined with volatility overseas in China and other Asian markets, September could provide several buying opportunities. Universe of Stocks Under Consideration The stocks at the top of my list change slightly from week to week: AAPL, MMM, JPM, JNJ, NKE, ABT, UNH, XOM, CVX, PG, PSX, UTX, EMR, PEP, GILD, UNP, RDS.B, KMI, CAT, KO, T, STWD, OXY, COP, KKR, NFLX, WMT, PANW, MO, HD, PBY, EV, SCG, DLR, KSS, BPL, OHI, ETN, PFE, GIS, KMB, CAH, TOL, FCX, CYS, NLY, AGNC. These are stocks that I am most interested in and have performed due diligence on, but market opportunities may present in other stocks as well. Important Upcoming Ex-Dividend Dates 2 September: Baxter International (NYSE: BAX ) PepsiCo, Inc. (NYSE: PEP ) Coca-Cola Enterprises, Inc. (NYSE: CCE ) 9 September: Occidental Petroleum (NYSE: OXY ) 11 September: The Coca-Cola Co. (NYSE: KO ) General Discussion I was caught completely flat-footed by the market break on Monday 24 August 2015. After I finally got into my account, prices were racing higher like a car speeding along without a driver. Charts were taking several minutes to call up, making them useless. Basically, Monday was a lost day for trading, but fortunately there was no harm done. The major lesson of the market during the week was that corporations are watching their stock prices closely for opportunities. The Goldman Sachs buyback desk had its busiest day ever on Wednesday, when the market finally resolved its weakness to the upside. People always talk about a government “plunge protection team,” but the true supporters of the market are companies using cheap credit to buy back their own stock. My sense is that anything related to financials is going to be weak during early September. While some asset classes, such as REITs, appear to have priced in much of a September rate hike, other classes might not have done so yet. When vice chair Fischer said during his CNBC interview that market volatility would play a role in whether the Fed acted, I was surprised. That seems like a screwy rationale for raising or not raising rates. He may have said that just to calm the markets, which seemed to be a major objective of Fed personnel past and present during the week. If the Fed needs market volatility to postpone a rate hike, I’m sure the market would be happy to oblige. The key for the market is the uncertainty about what might happen, not what will actually happen. Fischer eliminated one potential uncertainty when he said that rates would rise in 25 basis point increments, but that was a minor point. At this point, it may be just as important what the Fed says about a second rate hike as whether it does one in September at all. The market hates uncertainty, so my focus this week heading into the all-important jobs number will be on interest-rate sensitive stocks such as banks and REITs. It is more likely than not that a new trading range will develop in the vicinity of current levels. My eye, along with everyone else’s, has been on the energy sector. As usual, the market seized on some transient concern – Saudi Arabian troop movements, a call for an emergency meeting of OPEC – to force shorts to cover. The supply/demand imbalance continues, though, so unless the energy market finds some new worry, the current rally is likely to fizzle. In addition, the Iran deal is a lock, and that will release even more oil into the market, so I am in no rush to add the oil plays I covet, including Exxon (NYSE: XOM ) and Chevron (NYSE: CVX ). The bottom line is that the market has its eye on the Fed, and until that clarifies, the trend into the end of the year will remain unclear. Actionable Ideas I still will be keeping an eye on Apple for any buying opportunities. The REITs such as CYS, NLY and AGNC are buys on dips, as is OHI. Realty Income (NYSE: O ) I would like in the low 40s. PEP will be of interest on a dip into the 80s, where it has support. MMM around 140 would be interesting, as would JP Morgan (NYSE: JPM ) in the low 60s. Looking through the charts, there still are a number of stocks near enough to their peaks that further distribution would not be unusual at all. September definitely is a month to be opportunistic. Conclusion Last week was a successful week of trading, but volatility still looms from multiple sources. Anyone thinking that we are headed straight back to all-time highs is much more bullish than I am. The next two weeks are more likely to be a good time to be opportunistic and grab some plays on dips, especially as the market dates of doom – the jobs report and the Fed meeting – approach. Disclosure: I am/we are long CYS. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The positions being discussed are for a portfolio I manage for someone else, not my own holdings.

The Time To Hedge Is Now! 2 New Candidates To Add Before It’s Too Late

Summary The introduction contains a brief overview of the series. A couple of things to consider for those still on the fence and unhedged. A list of candidates including two new ones to consider. A discussion of the risk inherent to this hedging strategy relative to not being hedged. Back to Or Is IT Too Late? It is not too late to hedge, but doing it cheaply is getting harder. Most of my positions are working, but not all have shifted into gear yet. Some are not sporting gains as high as 1,200 percent. But this, as series followers know, could be just the beginning. If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog. It may be more difficult to follow the logic without reading Parts I, II and IV. In Part I of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process, and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options, and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December 2014 update explains how I have rolled my positions. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term, you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but had also have eliminated the big losses. It makes a really big difference in the end. A note specifically to those who still think that I am trying to “time the market”, or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five-year period, I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more, I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point, the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. A couple of things to consider for those still on the fence and unhedged In my last update I mentioned the two things I am going to be watching on Monday morning are what happened in China equities and whether or not the price for WTI crude oil has held above $40 over the weekend. As I write this late Sunday evening, the Shanghai Index is down by over seven percent. That is not a good sign! I just checked the price of WTI crude oil and it currently stands at $39.37/bbl. This is also not a good sign. I may be wrong, but I suspect that U.S. equity markets will open lower on Monday once again. Chris Ciovacco does a weekly video that focuses mainly on technical analysis of U.S. equity markets. This last week was particularly interesting. He is very balanced in his approach, neither a bull nor a bear. He has a good set of rules that he strictly follows. It is well worth a few minutes to watch. Another eye opener is this article about falling container rates from Zero Hedge. This site tends to be mostly bearish but they do make some good points. I think this one is worth considering. A list of candidates including two new ones I will start with the two new candidates that I want to add for your consideration. I plan to try to add a small position in each as described below near the opening on Monday. First up is Masco (NYSE: MAS ), a manufacturer of home improvement and building supplies. I realize that the housing market has been humming lately and that is why this company has so far escaped the ravages of the last few days. As of Friday’s close, Masco was down only 7.2 percent from its 52-week high. If the U.S. economy falls into a recession MAS will catch up with the falling market and could potentially hit as low as $10. Back in 2011, the last time the U.S. economy barely kept from falling into a recession, MAS stock fell below $7. In a recession home building and improvements slow down as people either lose their jobs or postpone major purchases out of fear that they may lose their job. Masco Corp Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $26.53 $10.00 $25.00 $0.30 $0.40 3650 $4380 0.12% I will need to purchase three January put options with a strike of $25 to provide myself with the protection shown above. The next new candidate is Coca Cola Enterprises (NYSE: CCE ) another sleeper that has not been beaten down yet. The company sold all of its North American bottling operations to the Coca Cola Company (NYSE: KO ) in 2010. The current company has operations in Great Britain and much of continental Europe. When the next global recession hits, and it has already started in Europe for all practical purposes, it will be become increasingly difficult to maintain sales volume. That has already begun as sales in quarter one of 2015 were down 13 percent compared to the same period last year. Profits were down nine percent. Yet, the share price has held up nicely. I do not believe that will last as the pressure to cut prices in an effort to maintain volume will narrow the profit margins. CCE stock price on Friday closed at $51.79, only 3.7 percent off its 52-week high. I believe this is another issue that will play catch up once investors catch on. Coca Cola Enterprises Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $51.79 $24.00 $45.00 $0.65 $1.05 1900 $3,990 0.21% And now for the rest of the list. I will not go into detail on why I expect each candidate will fall as I have done so in past article at length. Readers who want to understand my reasoning better can find those details in the early parts to this series. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.28 $8.00 $22.00 $0.35 $0.50 2700 $4,050 0.150% I would need three January 2016 GT put option contracts to cover approximately one eighth of a $100,000 equity portfolio. If you already own a full position of GT options, do not exchange those for the new position. This would only add to your cost by increasing transactions. This new position is for anyone who has not yet completed their position or who may be rolling over to replace a July position. This statement applies to all of the “new” positions listed in this article. Do not trade in and out of positions to try to improve your overall position. That just defeats the purpose of keeping this strategy affordable. A better strategy is to average into a position over time, lowering your average cost basis with each purchase. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $83.31 $24.00 $70.00 $1.35 $1.90 2321 $4,410 0.190% I need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $74.51 $16.00 $60.00 $1.05 $1.70 2253 $3.830 0.170% I will need only one January 2016 TPX put options to complete this position for each $100,000 in portfolio value. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $85.71 $22.00 $70.00 $1.78 $1.99 2312 $4,601 0.199% I need one January 2016 RCL put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $69.33 $30.00 $60 $1.55 $1.75 1614 $2,825 0.175% I need one January 2016 MAR put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. E*Trade Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $25.54 $7 $20.00 $0.60 $0.65 1900 $3.705 0.195% The position shown above would require three January 2016 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $80.29 $30.00 $70.00 $1.95 $2.20 1741 $3.830 0.220% I need one January 2016 LB put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $34.21 $15.00 $28.00 $.61 $.71 1731 $3.687 0.213% I need Three January 2016 MS put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $59.58 $16.00 $55.00 $2.65 $3.10 1158 $3,590 0.310% I need one January 2016 KMX put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Sotheby’s (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $35.90 $16.00 $30.00 $.85 $1.05 1233 $3.885 0.315% I need three January 2016 BID put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Summary My eight favorite positions at this point include the two new candidates, MAS and CCE, along with BID, KMX, RCL, MAR, WSM and LB. The China problems should spill over into the BID stock performance soon. The remaining five are dependent upon a U.S. recession, which I now believe will be difficult to avoid. A discussion of the risk If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises, the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risks for a moment now. Obviously, if the market continues higher beyond January 2016, all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. If the market somehow rights itself and the bull market continues into 2016, all of these positions could potentially expire worthless unless the stock price associated with specific puts is below the strike price. It is insurance against catastrophic loss, not a get rich quick scheme. There is a price to pay for insurance. Worst case we will likely be able to scalp some more gains from MU and possible one or two others when it comes time to roll positions if the bull regains its footing. If that happens I will establish new hedge positions with expirations out to January 2017. I could be wrong, but I really do not think we will need to wait that long for the hedge to work. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I hold, or will purchase, put options on all the companies listed in this article.