The Rally Is Overdue For A Pause

Summary

• We continue to see a huge rotation in the market into economic sensitive sectors like manufacturing, travel concerns and energy.
• Investors are betting that huge amounts of stimulus could trigger a substantial economic rebound in the second half of 2020.
• A strong May Jobs Report and other recent economic readings are tending to support that belief.
• However, volatility in the market is not going away, and stock holders might be getting somewhat ahead of themselves.
• My current read on the market and how I'm positioning my personal portfolio is outlined in the paragraphs below.
• I do much more than just articles at The Biotech Forum: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

From one dog all the dogs bark.”― Marty Rubin

Despite the continued nationwide protests in so many major American cities, the market continued to rise last week and has continued to rise Monday. Boosted by a big rally Friday, the Dow Jones Industrial average was up almost seven percent for the week. The S&P 500 was up nearly five percent on the week and the Nasdaq rose 3.4%. Equities continue to see a massive rotation into economically-cyclical areas of the market like manufacturing, energy and travel concerns. Airlines had a huge week as travel demand is starting to come back and the industry is adding flights. Financials also had a big week as interest rates rose and concerns about consumer defaults lessened.

Investors are increasingly optimistic that the massive and historic amounts of stimulus via recent legislation, the U.S. Treasury and the Federal Reserve that will continue to hit the economy in the months ahead will trigger a strong economic rebound in the second half of the year.

That belief got a big shot of confidence Friday when the May Jobs Report came in much, much better than anyone predicted with some 2.5 million jobs being added during the month. An eight million job loss for the month was the consensus. In addition, economic activity in the San Francisco region has returned to pre COVID-19 shutdown levels. The POTUS also signed legislation that will adjust the Paycheck Protection Program late this week. This revision should be a significant benefit to small business and particularly restaurants and hotels that have been crushed by the COVID-19 pandemic.

The Nasdaq is now trading higher than it began the year despite continued uncertainty still on the economic and COVID-19 containment fronts. Here are some of my current observations on the economy, the markets and other events.

First, I think the protests, despite the huge gatherings over the weekend, happening in places like New York City, Chicago and Washington D.C., will slow down substantially by this time next week. First, absent a new trigger, these types of mass events tend to eventually go away. In addition, the jobs report put the administration in a much stronger negotiating position on any further stimulus legislation. The $3 trillion stimulus bill in the House passed in mid May was on life support before Friday's jobs numbers. It's deader than a doorknob now. Without help from the federal government, many cities like New York and Chicago will have to make massive cuts to services and/or significantly raise already sky-high tax rates. California now has an almost $55 billion budget gap. This might prod mayors and governors in these affected areas to take stronger measures to quell these marches should they not collapse under their own weight in the week ahead.

It's too early to speculate on if or what form any further stimulus package will look like. If I had to guess, I would imagine it will involve federal assistance to cities and states in return for some sort of temporary payroll tax cut to further boost the economy. This will definitely be a "watch item" in the weeks ahead.

Going back to the May jobs report. I would take the numbers contained within with a massive grain of salt. The country has had an unprecedented economic contraction and the first nationwide economic lockdown in its history. Measuring the current state of the jobs market a few days after the month ends is basically impossible. I expect several substantial revisions to the May report before it's "final." My guess is that last revision will show the loss of several million jobs in May, but still much better than the consensus going into Friday. RBC Capital's economist has projected June could see an almost 10 million job gain. Hopefully as more and more people get back to work, societal tensions lessen nationwide.

The worst-case scenario of so many pundits seems to be off the table. As was posted Thursday, almost 43 million Americans have filed unemployment claims over the past 11 weeks. However, some 20 million appear to be already back at work which is an encouraging sign for the economy and the jobs market. In addition, Bloomberg reported Friday that economic activity has already returned to pre COVID-19 levels in the San Francisco region.

My most likely base scenario continues to be the U.S. economy will have a strong U-shaped economic rebound in the second half of 2020. However, some of the numbers we saw this week make a V-shaped somewhat more of a possibility. Outside a major new COVID-19 outbreak in fall, I believe an L-shaped scenario is pretty much off the table at this point.

That said, I think the rally in equities has gotten ahead of itself and now is the time for some caution. If anyone would have told me that my personal portfolio would be within a few percent of its highs prior to the COVID-19 market meltdown by the anniversary of D-Day in late March, I probably would have looked at him if he had three heads.

You can see the rally in many parts of market has likely overshot. Look at Camping World Markets (CWH), a name I added to substantial via covered calls in March and the first part of April. The stock of this RV concern is up substantially from where it began 2020 even as the consensus EPS estimate for FY2020 has been cut by two thirds over the past three months. Does that make any sense? I see this same type of development in many other stocks and sectors.

In addition, "companies in the S&P 500 are forecast to report a 43% drop in earnings in the second quarter, which would mark the largest year-over-year decline in profits since the last three months of 2008, according to FactSet." This leads me to believe at some point this summer we will see at least one significant bout of profit taking even as the economic restart continues to gain steam.

Currently my personal portfolio is at about a 15% cash allocation. Over 80% of my equity holdings are within buy-write also known as covered call positions. I'm more than content to continue to let those positions expire in the money and build up that cash position every third Friday of each month on options expiration day.

I continue to make some small bets almost entirely via new covered call positions. One name I added to late Friday was in Entercom Communication (ETM), a holding company for radio stations across the United States. While the stock has doubled in short order, the shares are still at less than half the levels they began the year at.

Radio advertising should get a nice boost from the coming NFL season as well as the restart of MLB and NBA play. In addition, heavy political spending for the 2020 election will surely boost revenues. Even with the recent rally in the shares, the stock yields north of three percent. The stock saw considerable insider buying during the meltdown, and its Chairman Emeritus bought over $1.5 million worth of new shares in three transactions from May 18 to May 20.

Option Strategy:

I added exposure to Entercom Friday in the following manner. Using the December $3 call strikes I fashioned some Buy-Write orders with a net debit in the range of $1.75 to $1.80 a share (net stock price - option premium). This strategy provides approximate 25% of downside projection and could deliver a potential over 65% return over six and a half months even if the stock just gets back up to the $3 level. Far below where the shares started 2020. That is at least a "stand up double" in my book.

And those are my current thoughts on the market.

A river is easier to channel than to stop.”― Brandon Sanderson

Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum

Analyst’s Disclosure: I am/we are long CWH, ETM. 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.