Options Trader: Wednesday Outlook

by: Philip Davis

[chart]Are we there yet?

Clearly there are signs of sector rotation.  This chart from the WSJ shows money has been flying out of Energy and Materials in July and August and moving into Consumer Discretionary, Health Care, Consumer Staples and Financials but the broader market is simply not feeling the effects yet.  A 15% drop in the energy sector, which makes up 20% of the S&P cost that index 3% in the first 2 months of Q3 yet we are flat to where we began the month of July - things are indeed better than they seem as Materials cost the index another point at least so we’re looking at a 4-point improvement AND the dollar is up almost 10%, which is another 120 S&P points we’re not seeing.

Stocks are commodities that are priced in dollars so a a strong dollar buys more stocks.  The $1,000 worth of the S&P you owned on July could be traded for 7.14 barrels of oil on July 1st but now buys us 9.09 barrels of oil - that’s a 27% increase!  On July 1st our $1,000 worth of stock could buy us 1.05 oz of gold, now it buys us 1.23 oz, a 20% increase!  Against a CRB basket of commodities, that $1,000 is up 20% overall and THAT is why the markets aren’t going anywhere - they are but we are not appreciating the increased purchase power of our dollars.  

As option players this puts us in a dangerous position, we need price movement in the stocks we bet on, not value movement.  Value movement is great when you own the underlying security but phantom 20% gains do us no good at all when the dollar price of the stocks we bet on is flat-lining.  Now we have to go back and rethink a lot of our bets, probably moving back to more of a premium selling strategy as money is pouring into the US equity market from foreign countries, it’s just buying 20% less stock than it used to!  This makes it very hard for our equities to gain traction and we’re going to have a lot of assumptions to question if this dollar strength continues to have this effect.

I pointed out in yesterday’s post that the S&P priced in Euros is up 20% off it’s July 15th low and yesterday’s bounce off the EU resistance level of 8.93 (per the StockCharts conversion) is nothing more than a 20% rule pullback, which may drop us 5% but is almost certain to end in a breakout above 9, which would be 1,300 on the S&P.  Once US investors get on board, the 200 dma priced in dollars is way up at 1,350 and holding the USD 50 dma at 1,272 will be perceived by EU-priced observers to be a very bullish technical move.

Looking at the market this way allows us to really see who’s leading and who’s lagging in the current horse race.  AAPL, for example is up 6% in Euros since July 1st, well behind the broader market and GOOG is down slightly, but much better than the 10% decline it’s had so far in Q3 from our dollar perspective.  Both stocks are trailing miles behind the 10% gain in Euros posted by the Nasdaq in the past 60 days.   Even the pathetic SOX looks like they are performing when priced in foreign currency, up 10% over the same period.  On a happy note, oil is down 20%, even when priced in Euros and yesterday’s bounce off $105 was exactly a bounce off the 200 dma of oil priced in other currencies even as it finished BELOW our USD-priced 200 dma.

So is this good news, bad news or what?  Well, that’s a little hard to say.  If we own US equities, it’s fantastic.  We are so used to the idea of our dollars being worth less (worthless) in the future that the idea of simply saving them being a good idea has become a foreign concept to investors but  you can now buy more home with your stock, more food, more oil etc so holding flat against falling commodities is great and it makes bonds very attractive as they have little risk and give you 4% interest IN ADDITION TO the 10% gain in the dollar without the heartache of playing the market.   As I said, that is not good news for short-term option plays - more money goes to bonds, which are making an excellent play on the rising dollar and the rapidly declining commodity sector weighs down on the broader market and inflates the dollar further, which keeps equity prices (in dollars) low over the short run. 

The dollar fell from 90 in early ‘06 to 75 last November (17%) while the S&P climbed from 1,300 to 1,576 (21%) so MOST of the gains we did have over that time were currency fluctuations, not value improvements.  It’s going to be very hard to dig down and find the real value as the dollar approaches "normal" but let’s keep in mind that we are still LOWER on the S&P now than we were when the dollar was 17% higher.  It’s the US investors that are making the difference, money is flowing in from foreign markets but US investors are living in an environement of such fear, devoid of leadership, that the markets are simply out of favor.  The upcoming election uncertainty is also spooking investors as is the "Fake Bank Crisis Story of the Week" club, which seems to have many, many members.

A rising currency didn’t stop the European and Asian markets from having a fantastic run for the past few years and a declining currenty isn’t preventing them from collapsing now so currency is not the be all and end all of the markets.  It seems that there are many beaten-down US equities, like GOOG, CAT, C, PEP… that will be excellent places to have money parked as the dollar comes back along with the stock.  This explains the extremely good performance of our Stocks portfolio this quarter as our strategy of holding stock and selling calls against it has been perfect for a flat-lining market.

We need to scale back our expectations for a great rally in the market as we’re already up 20% from a global perspective and 10% a month is difficult to sustain (although China did it for 2 years), 10-15% gains from here by the end of the year will be a remarkable gain by for US equities if the dollar remains above 75.  We will be hard pressed to retake 1,500 on the S&P (up 15%) and 13,500 would be amazing on the Dow, even if oil continues to pull back - we need to lower our expectations to reflect a broader global perspective.  I’m cerainly not saying we shouldn’t own stocks, these will be great gains - but playing for a big, short-term run-up on the options side is likely to be a mistake.

I don’t have all the answers here and I would appreciate members’ thoughts on this as it’s going to be a tricky investing climate.  Let’s look for equities that are a bargain for foreigners, especially good dividend payers as the dollar will be king and getting them paid to you quarterly will be a big deal, even if capital gains do go back to 20%.

This also means that we can expect the S&P to retest 1,266 and the Dow to skim along the 11,500 mark for a while, we need to lower our dollar denominated expectations for what constitutes market strength.  This is all part of a process that US investors need to go through as we begin to recognize the fact that we are no longer the World’s economic leader and our financial fate is deeply tied to the global markets - being $10 Trillion in debt will do that to you…

We owe Japan over $1Tn and a rising dollar is good news to the carry traders, who borrow Yen to invest in dollar-denominated assets.  Bonds look VERY attractive to them in a rising dollar environment as they arbitrage the currency and that helps to keep our short-term rates lower than would be expected in an inflationary environment.  The Nikkei took a hard bounce off 12,500 yesterday and added 200 total points by the end of today’s trading to finish at 12,689 as oil broke back down in overnight trading.  As with the US, airline and auto stocks offset sharp declines in the energy sector.  The Hang Seng fell another 457 points, retesting the Aug 21 lows of 20,400 and finishing at 20,585.  KO took my advice and went bottom fishing in China, offering $2.4Bn for the China Huiyuan Juice Group, which would make them the largest seller of non-carbonated drinks in China (Huiyuan has a 10.3% market share, KO already has 9.7%).  This deal is subject to regulatory approval in China and is a bit monopolistic but the better than 100% price premium offered by Coke is just the statement the Chinese government wants to make that their equities are now undervalued so well played by KO, that extra $1Bn is likely to be well spent over the long haul…

Other juicy news in Asia is escalating violence in Pakistan and Thailand still has issues but global M&A is surprisingly still at 73% of last year’s levels at $2.5Tn and that is the opposite spin of the WSJ who headlines it falling 27% but $2.5Tn is still considered a lot of money in some circles and acquisitions of minority stakes in companies is up 28% at $500Bn so there is a lot of global bargain hunting going on.  We’ll be watching the Shanghai, now at 242 and down 60% for the year to see when the madness will end.  India has been on a tear and is up 1,000 points in the past 3 days in celebration of the strong dollar, a party China has yet to join in on.

Europe is having a bad day, down about a point across the board as even the Chinese Yuan is rallying against the Euro as that economy grinds to a halt.  The only thing worse than the Euro right now is the British Pound, making all-time lows against the currency they didn’t want to join.  Remember this was all triggered by Ireland’s rejection of EU membership which threw the Union into turmoil and gave us the green light to go long on dollars back on June 12th - see how all this paying attention to world politics pays off!

So we’re still looking for that Nasdaq leadership to take us higher as those companies should give us the most bang for the rising buck, let’s watch our lower levels and keep our eyes open but the bears are losing their case, bit by bit and if we can keep a $110 lid on oil, this market is ripe for another leg up - just a little smaller than we had previously been hoping for.