Leveraged Dividend Investing

In a previous article I mentioned that my current dividend income stream is close to covering anywhere between 60% - 80% of my total monthly expenses. My strategy for reaching the dividend crossover point includes saving and investing every month in dividend growth stocks with attractive valuations and long term earnings and dividend growth potential, while patiently reinvesting distributions. At this rate, It would take me several years before I reach my dividend crossover point, which is equivalent to financial independence or retirement.

This means that if I could theoretically double the size of my investment portfolio, and have it yield close to what my portfolio yields today, I could achieve financial independence right away. In other words, if I were to borrow an amount that is equivalent to the value of my portfolio at low interest rates, and have it yield more than my cost of capital, I could achieve my dividend crossover point much faster. I researched the margin rates for online brokers in the US and found out that Interactive Brokers has the lowest rates for using margin.

Currently, an account with a margin balance between $100,000 and $1,000,000 can borrow at 1.38%/year. The rate on the first $100,000 in margin is 1.88%. Let’s assume that an Interactive Brokers customer invests $500,000 in dividend paying stocks yielding 4%. This portfolio would be expected to generate $20,000 in annual dividend income/year. If this investor borrows an additional $250,000 from their broker, they will pay an annual interest of 1.58%/year.  If they invest the rest in dividend paying stocks yielding 4%, they would theoretically increase their dividend income to $30,000, or a cool 50% increase. The investor will incur an interest charge of $3,950/year, which brings the net dividend income to a little over $26,000, which is still 30% more than before. Given the fact that many dividend growth stocks typically increase distributions every year, this investor would be able to reach the desired level of dividend income much faster.

Have we reached the bottom?

With the S&P 500 being down over 30% year to date investors are getting nervous about their sinking retirement accounts. Many are simply throwing the towel and converting a majority of their stock mutual funds into bond funds in order to prevent their investments fall further in case we experience the next great depression.
Still there are some brave souls out there who are either keeping their retirement contributions or even increasing them.
With the stock market charts drawing steep vertical declines for September and October, and the VIX reaching multi-decade highs many investors are wondering if we have reached a bottom. Fundamentals might be deteriorating in the near term; however that shouldn’t mean that the stock market should keep going lower. When the stock market hit its all time highs in early October 2007 almost everyone was bullish on stocks. Furthermore the financial crisis was still in its infancy as few investors had the vision to foretell the complete meltdown of the system including failures at Lehman, Bear Stearns, AIG or Fannie and Freddie. So what are the charts saying?

The market has been in a consolidation mode ever since it hit its lows for 2008 in October. The market is over 15 % above its lows for the year as of now. The major market indexes ignored the news about the contraction of the US economy in the third quarter and the slump in consumer spending by recording their biggest weekly advance since 1974. The rosy short term situation would definitely end on a decisive move below the year lows at $83.58.
During bear markets there usually are several bear market rallies which cause major market indexes to rise significantly off their recent bear market lows. Another feature of most bear markets is analysts trying to time to bottom at the expense of investors. I did try doing exactly the same in March as well. The thing is that as long as the market keeps making lower highs and lower lows, then the technical picture is bearish. If the market breaks the pattern of lower highs and lower lows, it could then start charting a bullish picture for equities.
Levels to watch on the upside include 105.53, which was a reaction high straight from October lows and is close to a 50% retracement of the last leg of the bear market from the August lows. Other levels to watch on the upside include 113.15 as well as the 120-124 area. I see the 120-124 area as the toughest to break out of as it previously marked 3 intermediate term bottoms in 2008.

Full Disclosure: Long S&P 500

Relevant Articles:

- Average Durations of Previous Bear Markets

- The Bottom is in

- SPY at a crossroads

- What Is The VIX Index

Can money grow on trees?

I was researching alternative assets classes that not only could perform as well as the stock market but also provide good diversification opportunities as well as passive income possibility. One asset class which seems a little overlooked is timber.
According to several websites that I found, investing in timber has beaten the stock market by 4 percentage points from 1973-2003.

There are several advantages of investing in timber:

• Timber is uncorrelated to stocks
• The price of timber has consistently beaten inflation by 3.3% over the past decades
• Unlike other commodities, trees grow every year by 4% - 10% and as they age their wood becomes more valuable
• Even if prices decline, you can decide not to cut your trees in a given period. Your trees would be growing no matter what you decide to do with them.
• You get certain tax breaks – your profit is taxed as a capital gain. On top of that, as timber is cut, another tax break called a depletion allowance kicks in.
• You could invest in timber REIT’s, like PCL and RYN, which are publicly traded on NYSE
• The Food and Agricultural Organization of the United Nations forecasts that world demand for wood will nearly double by the middle of this century.
• The USDA-Forest Service projects that demand for U.S. forest products will reach 25 billion cubic feet annually by 2050, up from nearly 18 billion in the 1990s.

There are several disadvantages of investing in timber as well though

• Most direct timber investment is limited to wealthy individuals who can chip in at least $1,000,000 to $5,000,000.
• Timber Investment Management Organizations typically require a ten year lock up period to their investors
• Timber Investment Management Organizations typically charge hedge fund like fees of 1% on all the assets invested plus 20% of the annual profits. It seems like you do need some managing of your forests in order to maintain them.
• Trees could be subject to fires. 0.5% of all trees suffer from this
• Trees could suffer from disease’s, so one should spread their timberland holdings across the globe
• Timber investments have soared form 1 billion in 1989 to more than 20 billion by 2005. Seems like the market is getting crowded.
• Even though timber investments have provided investors with 22% annual returns on average form 1987-1996, the returns have dropped to 8 % over the past decade
• Demand for timber is subject to cyclical swings in the economy. If housing starts plummet or manufacturers need less cardboard, then prices could plummet.
  
  You could find more information about investing in timber under the following links below:

Investment University , Financial Planning , MSNBC, Tropical Hardwoods( I am not sure if this last link is the real deal or not, so please use with caution)

My financial resources are still less than 1 to 5 million in order to invest directly in timber. For diversification purposes though, I am considering investing in RYN or PCL. Stay tuned for my analysis of these two companies.

Outperform S&P500 with S&P500 futures, Part 2

It is a well known fact that over time the stock market is in a long-term secular bull market. We do get potential hiccups like the Asian financial crisis in 1997-1998, as well as some major bear markets like the one after the 1929 crash, the1973-74 bear market and the 2000-2002 burst of the internet bubble. Since the stock market always seems to recover from any declines over any period of time, I believe that a long-only approach for holding a basket of stocks like the S&P 500 would be a profitable strategy in the long run. In my previous article (Outperform S&P500 with S&P500 futures, Part 1) we learned that an investor can participate in the upside or downside movements of the index with only a controlling stake ( the margin requirement) of 10% of the value of S&P 500 e-mini futures contract. So what could the result be if we try to enhance our S&P 500 exposure through investing in stock index futures? It is possible to achieve the 1.25, 1.5 or even 2 times the annual percentage return of the S&P 500 index through buying more contracts covering a higher dollar amount of S&P 500 companies. This strategy would be profitable in the long run only if done with at least several million dollars in order to correctly enhance the annual portfolio return. So lets say that we start with $10,000,000 and for simplicity sake the S&P 500 is trading at 1,000 at year end which means that every e-mini futures contract is valued at $50,000. We would like to achieve a 1.25 times the return of the index. Thus, instead of buying 200 e-mini contracts, we would buy 250. We would have to roll-over each quarter the futures contracts that we have and try to maintain their number unchanged over the course of the year. Let’s say that at the end of the year the S&P 500 is trading at 1,100, which is a 10% annual return. Our contract is valued at 55,000 now. But since we have 250 contracts, our annual gain is 12.5%. If however the index fell by 10% we would lose 12.5%. We need to rebalance our portfolio every year however, in order to accurately try to achieve a 1.25 times the performance of the underlying. Assuming that we had a gain in year 1 of 10% the value of our enhanced portfolio would be $11,250,000. This could allow us to buy 204.55 contracts at the current value of $55,000. In order to achieve a 1.25 times the enhanced return in year 2, we need to own 255.68 contracts. Unfortunately though, one cannot buy fractions of futures contracts. We could however substitute the fractions with ETF’s covering the S&P 500 index. .68 contracts @ $55,000 equal $37,400. We could simply buy around 340 shares of SPY, which normally trades at around 10% of the value of the S&P 500 index.

This strategy works very well during bull markets, since it compounds your gains significantly. During bear markets though, an investor using the enhanced approach would suffer higher losses than those who invest using the non-enhanced approach. It would take investors much more time to recover from the enhanced losses and thus the strategy would have to deliver very high results in order to recover to the breakeven level. If you refer to figure 2, you will see that a 10% loss only requires an 11% gain to recover. However, once you lose over 50%, you need to achieve enormous gains JUST to break even.

Thus, I would not enhance my exposure to S&P 500 through futures by more than 1.25 times. If your exposure is 2 times, then you will be wiped out if the index falls by 50% in a given calendar year. In order for me to be wiped out with a 1.25 times exposure, the index would have to fall by 80% in a calendar year.

Outperform S&P500 with S&P500 futures, Part 1

The S&P 500 futures contract comes in two sizes – S&P500 (SP) or e-mini S&P500 (ES). The SP moves by $250 for every 1 point move in the underlying index, while the ES moves by just $50. Thus if the futures are trading at 1330, if you buy one SP contract you are basically buying 250*1330= $332,500 worth of stocks. When you buy one ES contract, you are basically controlling one fifth of the large contract or $66,500. Another major difference in both contracts is the fact that the large one is traded primarily on the floor of CME, while the e-minis are traded electronically, almost around the clock. The contracts always expire on the third Friday of each March, June, September and December.

The futures do not pay dividends, but they also trade at a premium to the S&P 500 index, which declines as the index reaches its expiration day. The beauty behind trading the e-minis is that to trade one contract, you need to put only 4,000-5000 dollars in collateral. Thus, for less than 10% of the underlying contract value on the ES, you can participate in any upside/downside movements of the index. Thus if you had $66,500, you could simply buy one contract, put around 10% for margin requirements and then have 60,000 dollars in cash sitting idle. You earn money on the margin requirement because you have put the funds in a money market fund. With the remaining $60,000 though, you could create a bond/ CD ladder in order to make money from interest yields. The drawback is that you must trade 4 times a year in order to be fully invested in the index, because the contract expires every quarter. Most brokers allow you to trade the e-minis for as little as $2.40 per contract, which is less than trading $66,500 worth of SPY for example. Another drawback is that the index is settled every day, which means that if the S&P500 futures decline by 10% from your initial purchase at 1330, you will have to deposit and extra 133*50=6650 dollars to your account, otherwise you will get a margin call.

On December 31, 2007 the E-mini futures closed at 1477.25, while the S&P 500 index closed at 1468.36. The dividends during 1Q 2008 are expected to be around 7 points. Thus investors would have to achieve around 16 points in interest income just to break even. In order to achieve 16 points from interest, you need to have interest income of around 1.08% per quarter, which is 

an APY of 4.37%. 

Any yield that the investor can achieve above 4.37 % APY would result in him/her outperforming the index. In today’s environment of rapidly declining interest rates though, it might not be possible to outperform the market using S&P 500 futures.

Using the interest rates from this website https://www.bankmw.com/Rates.aspx i was able to construct the following ladder ( on your left).

Assuming that interest rates decline, one would be able to outperform the S&P 500 slightly, assuming that the index does not fall more than 30% from its recent levels over the next 3 months and that interest rates decline below 4%. An analysis of the percentage draw downs in S&P 500 from its relative all-time highs could be very beneficial when constructing the ladder.

Tomorrow I would post my ideas on outperforming the market using an enhanced strategy.