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Another Way To Play The Consolidation Phase

Daily State of the Markets
Monday Morning - April 23, 2012

Good Morning. With yet another session spent inside the current tight little trading range on Friday, it is clear that the consolidation phase continues. The primary driver of the current phase appears to be an oldie-but-a-goodie: uncertainty. In short, traders are uncertain about what comes next on any number of fronts including earnings growth (earnings are only expected to be up 1% this quarter), inflation (which, for those of you keeping score at home, is currently above the Fed's target zone on a year-over-year basis), Europe (Spain and Italy are getting all the attention these days), China (is 8% enough?), the economy here at home (a slowdown of the BTE theme appears to be happening) and the calendar (can "sell in May and go away" work yet again?).

While our heroes in horns tell us that all will be fine going forward from an economic standpoint, that Europe won't take down the global banking system, that China's growth remains strong, and that we're currently in the early phase of a cyclical bull market (which tend to last at least a year), the bottom line is that the month of May is right around the corner. And last time I checked, selling stocks at the beginning of May and then doing something else for several months has been a profitable strategy for six straight years.

As I've documented recently, history also favors a consolidation phase - right here, right now. We've detailed the research showing that cyclical bull markets tend to take a break for a period of two to three months at the six-month mark (which occurred on April 2). We've talked about the fact that our cycle work points to a pullback during the early summer. And we've discussed that idea that stocks tend to struggle at this stage during Presidential election years. And then with the month of May quickly approaching, the idea that we may see more consolidation ahead appears fairly logical.

It was for this reason that I laid out four ways to play a consolidation phase last week. However, it was brought to my attention that I left out one very solid strategy in my little summary. So, in addition to "riding the range" (selling the top end and buying the bottom end of the range), hedging your favorite stock positions (Is AAPL still a favorite after last week? What about CMG or GOOG?) with some inverse ETFs such as SH and SDS, raising some cash in your portfolio, and utilizing a shorter-term trading approach to following the trend, you may want to consider a strategy to produce income with options.

Commonly referred to as a "buy-write" or "covered call" strategy, this approach offers a way for investors to generate income from the positions they plan to hold through thick and thin. For example, if you are long McDonalds (NYSE:MCD) and you think the stock (as well as the overall market) is not going to advance to any great degree in the coming month, you can sell or "write" call options on your position in Mickey D's. Doing so puts a little cash into your account from the sale of the option, which would also effectively lower your cost basis in the stock.

For more active investors, another nifty way to play this game is to use your "market exposure" positions (such as SPY, SSO, or UPRO) and then trade the relatively new weekly options on the position. Sell the options when the market is near the top end of the range (anything above 1390) and then you can buy them back for a profit when the S&P moves back to the low end of the range (at say 1360ish).

Better still, one could combine a market-timing approach with the trading of the weekly options. This approach keeps your overall account on the right side of the market's important trends and also generates some income each month from the "selling premium" strategy on your market positions.

In any event, I just wanted to make sure everybody knows that there are lots of ways to play the game right now.

Turning to this morning... It looks like a rough start to the week after Eurozone PMI's came in weaker than expected and renewed concerns about the debt crisis are emerging. Even a better-than-expected Flash PMI in China hasn't helped as European bourses are down more than 2% and U.S. futures are pointing to a sharply lower open.

On the Economic front... There are no data releases scheduled to be released before the bell.

Thought for the day... "Facts are to the mind what food is to the body" -- Edmund Burke

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: -0.32%
    • Shanghai: -0.77%
    • Hong Kong: -1.84%
    • Japan: -0.20%
    • France: -2.34%
    • Germany: -2.94%
    • Italy: -2.23%
    • Spain: -2.92%
    • London: -1.83%
  • Crude Oil Futures: -$1.15 to $102.73
  • Gold: -$16.70 to $1626.10
  • Dollar: higher against the yen, euro and pound
  • 10-Year Bond Yield: Currently trading at 1.928%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -12.98
    • Dow Jones Industrial Average: -114
    • NASDAQ Composite: -20.59

Positions in stocks mentioned: AAPL, IBM, UPRO, MNST

Positions in stocks mentioned: AAPL, IBM, UPRO, MNST

For more of Mr. Moenning's thoughts and research, visit

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Disclosure: I am long AAPL, IBM, UPRO, SSO, SPY, MNST.