This past week’s trading proved that if there isn’t
a strong direction to the market straight puts and calls can be
difficult propositions. The good news is sideways trading rarely lasts
and this coming week should see a big move—the question is—which way? To
find out let’s take a good look at…
WHICH WAY THIS MARKET IS HEADED
As you can see from the charts above the markets
have been going up, but the pattern they’ve traced does not bode well
for further gains. The big problem with the current rally is that it is
based on the belief that the Fed will cut rates at it’s next three
meetings—but if that overly optimistic scenario doesn’t unfold “look out
below!”
Unfortunately for the bulls there are gathering
indications the Fed may not play ball. Late Friday afternoon St. Louis
Fed President William Poole warned that the market should not assume
there would be any further rate cuts. Poole joined three other Fed
presidents who also echoed that warning earlier in the week but his
voice seemed to carry more force since he is a voting member. The Dow
dropped nearly 70 points late Friday when Poole’s comments were made.
Poole also cautioned "It would be a mistake for markets to bake into the
cake the assumption of ongoing rate cuts." And, "The (credit markets)
disruption seems to be declining a bit, and that's the direction we
wanted to go." He said the 50-point cut was necessary to send a message
to the markets that the Fed was ready to act to solve any financial
crisis. Poole feels that crisis has passed and credit markets not
functioning at the time have reopened for business.
An example of the credit markets returning to
normal is the corporate bond market was not functioning prior to the Fed
meeting. That market has rebounded and September closed with more than
$110 billion in corporate issuance, a record amount. The corporate bond
market has returned relieving the Fed of any compelling reason for
further cuts.
In addition the Fed's direct loans to banks hit a
high of $7.2 billion on Sept-12th and dwindled to zero by Sept-26th
showing that inter-bank lending had resumed. The conditions that pushed
the Fed into that 50-point cut have been reversed. All four Fed
presidents echoed that future rate "moves" would be data dependent—that
means we have to see some really strong signs of an impending recession
before we see any more rate cuts.
The big upcoming indicator of the economy will be the non farm payroll
report this coming Friday. Should the payroll report show that the
August loss of jobs was an accounting blip and the ISM show a positive
gain then the Fed will be back on the sidelines. In fact even worse than
no rate cut the next move will be a rate HIKE if inflation continues to
climb.
Regardless of any ‘official’ reports inflation is
rising—fast. The core PCE deflator may be falling but prices for
commodities, food and energy are exploding to the upside. That is real
inflation but the government doesn’t show it in the core rate.
Commodity prices posted their strongest September
gains in 32 years plus gold hit a new 27-year high on Friday at $753.
Meanwhile food prices are rising at the fastest rate in over 17 years!
Consumers on average spend 9.9% of their income on food and in just the
last year corn has risen 40%, soybeans 75%, wheat 70% and a loaf of
bread +24%. Milk, meat and produce have also risen due to the higher
cost of feed, fertilizer and transportation expenses.
The price of oil hit a new high on the Brent Crude
contract on Friday and the U.S. November WTI contract came within 34
cents of another new high on Friday. This level of inflation is becoming
dangerous and the Fed will need to address it very quickly or the
situation is liable to spiral out of control—the problem is lowering
interest rates will only throw gasoline on the fire—and the Fed knows
it.
Another problem concerning the Fed is the falling dollar. The U.S.
dollar index hit a record low on Friday of 77.67, the lowest price since
the index was created over 40 years ago! The freefall of the dollar
creates further inflation pressures since everything we purchase
overseas (like all that stuff at Wal-Mart and your local gas pump)
requires more dollars than it did before. Cutting rates and a slowing
economy combine to push the dollar lower--raising rates in a growing
economy raises the value of the dollar and slows the implied inflation
rate. The truth is the Fed does not want to be cutting rates in this
environment and will likely only consider another rate cut if the
economy begins to fall off a cliff.
The stage is set for a monster move on the non-farm
payroll news next Friday. While nobody knows the answer in advance it
definitely appears the market has already factored in the best case
scenario of a weaker job market and another rate cut on Halloween. That
means this market is at extreme risk if that scenario falls apart with
the jobs announcement.
Since all the factors are weighted towards further
rate cuts there is an extreme chance of a disappointment if the ISM/Jobs
data comes in positive. That possibility of a correction with the
removal of a potential rate cut from the outlook, could happen before
the jobs report if funds begin to hedge against a stronger jobs report
this Friday. Quite a few traders will not want to wait around only to
get blindsided by rate-cut unfriendly data so we could easily see
weakness before Friday.
However even if by some fluke the jobs report isn’t
a material factor this earnings season is going to be tough. Current
expectations for S&P-500 earnings have fallen to only +2% growth for Q3.
This compares to +9% in Q2 and +22% in Q3-2006. That is a significant
decline in earnings from 22% to only 2% in only 12 months. Remember
stocks go up for basically one reason—increased earnings
expectations—and right now those expectations are decreasing with a
market hovering at multi-month highs.
The Dow's closed Friday only 127 points from a
record high. The Nasdaq is only 23 points below its July high and the
S&P 25 points. Between the potential for a rate-cut disappointment and
the lowest earnings expectations in five years it looks like this market
could be in for a serious ‘adjustment’—the question is…
HOW DO WE MAKE MONEY ON IT?
We’ve got two plays lined up this week and you
better believe they are both bearish.
Our first play is a super low cost—but high
potential—position on an index with some serious downside risk. With
puts as low as .70 cents this play offers some truly lottery style
profits if things get a little dicey—if traders even get a whiff that
the Fed isn’t going to keep on cutting rates expect this market to
plummet like a concrete block jettisoned from a Cessna.
Our next play is on a retailer that we don’t have
to guess the direction on—it’s going down. With the worst holiday
shopping season forecast in five years you can expect the rats to
continue fleeing this sinking ship—but with a stock price up in the
triple digits this one still has a long ways to fall—a fall we’ll be
capitalizing on with some well placed puts first thing Monday morning.
We’ve got two super high potential plays and a
market teetering on the edge—so let’s get to it!
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