We are the playthings of time and volatility.
Sometimes those inexorable forces coexist peacefully, and life -- in and out of markets -- is uneventful and even halcyon. Other times they furiously collide. When profound change is involved, as now, the collision can be so shocking that basic truths are easily forgotten.
Consider these observations not as philosophical meanderings but as a way to understand recent market activity, when lackluster earnings stripped hundreds of billions of dollars -- and maybe more -- from benchmark indexes and top stocks.
Intel sparked the powder keg last week when the chip maker issued weak fourth-quarter financial guidance after beating third-quarter earnings estimates. The stock fell 29% and sharply increased anxiety about when artificial intelligence would generate corporate profits and not just massive expenses. Google parent Alphabet worsened sentiment by reporting negative free cash flow (again), further panicking investors with news of AI spending and slower growth in its search-engine business. Apple's results this week have deepened concerns.
If bad news from AI leaders occurred a few months ago, investors might have dismissed it. But the year ends soon, and the investor class is heavily focused on annual bonuses, which form the bulk of their compensation. Rather than characterizing sour results as the cost of building AI -- an innovation many investors, ironically, are using with great results -- the selloff could be rooted in seasonal sentiment and positioning shifts. We don't think it means investors have profound doubts that AI is the technology of the future.
After all, the S&P 500 index remains about 3.1% away from its record high and is still up 10.6% this year. The historically high return supercharges the magic of compounding for long-term investors.
To our thinking, the declines are opportunities to buy blue-chip stocks and sell bearish cash-secured put options. If another paroxysm occurs -- if the midterm election results weaponize Congress against Wall Street, say -- the opportunity to buy more stocks and sell more puts will again be attractive.
Consider Alphabet. Shares recently fell from about $325 to $280. The stock is down 10.5% this year, though it has more than doubled over the past three.
For investors with long time horizons, episodic short-term volatility is an opportunity for time arbitrage. This strategy monetizes short-term stock weakness by selling options with an elevated fear premium, benefiting long-term investments. It expresses a belief that blue-chip stock weakness, over long periods, is usually a buying opportunity, provided the stock can be held for at least three to five years and ideally much longer.
With Alphabet at $280.03, sell the January $270 put for about $10.60.
If Alphabet is below the strike price at expiration, buy the stock. If the stock exceeds the strike at expiration, the put premium is kept. The risk is the stock falls far below the strike, which could happen if something else makes investors panic. To manage the risk of further declines, "leg into" the trade. If you want to buy 900 shares, for instance, sell three puts with different strike prices and similar or different expirations.
Because we think AI will profoundly change the world, and that anything that poses major changes to the status quo is definitionally volatile, a broader approach is also worthwhile. The State Street SPDR S&P 500 exchange-traded fund will almost certainly advance when AI fears lessen. To pre-position, buy bullish call options that expire in one to three months and are a bit higher than the ETF's price. If you also sell puts on the ETF, you should raise enough money to pay for some or all of the call.
Don't let volatility scare you. Over time, embracing it creates wealth.
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