Dear Fellow Big Money Options Traders,

The 2008 meltdown fear and risk is back. The New York Times reported late last week that there are continuing fears of European bank failures and contagion to U.S. and U.K. banks. Bank of America (BAC) is at a 24-month low and trading well below half of its stated book value. This new level of fear was sparked by rumors that a eurozone bank borrowed $500 million for a week from the European Central Bank in a mostly unused facility last Thursday. Credit default swap spreads are rising on major banks, and the bears are making a push to create a Lehman-like event.

 

Gold and Treasurys are telling us that the risk of further market meltdown is high. Driven by a flight to safety, demand for Treasurys is high, and yields are being pushed down below where they bottomed in the credit crisis of 2008/2009. The graph below shows the 10-year Treasury yield during the past three years.

 

Two weeks ago, individual investors pulled $13 billion out of stock mutual funds. Last week, the exodus climbed to $30 billion. With money fleeing stocks and running into Treasurys and gold, it isn’t clear what causes stocks to stabilize near current valuations.
A collapsing market, falling Treasury yields and an elevated CBOE Volatility Index (VIX) tell us where the market is today. In an attempt to determine where it might be in the intermediate term, today’s Weekly Trading Landscape provides a survey of various market indicators so we can assess the risk/reward environment.
 
Relative Yield
The current S&P 500 dividend yield is 2.14%, which is higher than the 10-year Treasury yield of 2.09%. The current S&P 500 earnings yield is 8.4%. The combined dividends and earnings rate suggests a 10% return on investment by buying the S&P 500 index. Historically, the high yield of stock dividends and earnings relative to the deflated yield of bonds has been a bullish indicator.

S&P 500 Dividend Yield


 
Insider Buying
Insiders are buying stock at a pace valued 15% greater than the insider buying volume in March 2009 and is the second-highest buying spree recorded in the modern market era. So far this month, insiders have purchased $681 million worth of their own stock. Funds that have 10% or greater positions in a stock spent an additional $1 billion on building their stock positions this month.
 
Wall Street Strategists
If you poll the major Wall Street strategists, you’ll find that the average S&P 500 price target for Dec. 31, 2011, is 1,383. This represents roughly a 23% advance from Friday’s close. Depending on how you view consensus thinking, this could be either really bullish or really bearish.
The chart below shows both current and start of year year-end S&P 500 price targets and earnings projections. During the course of the next month, it’s likely that strategists will lower their earnings estimates. If stocks begin to stabilize or appreciate while analysts continue to reduce their numbers, this will provide a strong indication that the market has found its lows. As of today, we are not there yet.

Source: Bespoke Investment Group and Bloomberg
 
Market Sentiment
Measured by our market sentiment indicator, which has plummeted from 46.8 to 26.3 to 8.2 to 9.6 in the past four weeks (see chart below), the oversold level of the market has happened to this extent only four times in the past two decades, including this current instance.

 
History says that the market will be higher in the next 12 months. But during the next several days, weeks and even months, volatility likely will be elevated, and we could see new lows before we see new highs.
The four instances of a less-than-10% market sentiment reading and the subsequent six-month Dow Jones Industrial Average appreciation are shown below.
                         12-Month
Date            Market Advance

Sept. 1998             40%
July 2002               20%
Nov. 2008              25%
Aug. 2011               ?%
What the Fundamentals Say
The current fundamentals are mixed. Although it’s evident that the economy is growing slower than expected, it isn’t clear that we’re going into a recession. The most recent models used to predict recession are showing about a 30% probability of recession in the next six months. Rather than cataloging a list of positive and negative data points regarding the economy, below we’ve included the Leading Economic Indicator Index. July leading economic indicators were up 0.5% versus expectations of up 0.2%.

 
The correlation between the LEI and the stock market is very high. In March, the LEI index turned negative, which is represented as a wiggle in the blue line on the chart below. That down-tick was highly predictive of the current market decline. It’s also notable that the CEI (coincident indicator index) posted a good gain of 0.3% in July. This is another sign that the economy continues to grow.
As a reminder, the components of the index are:
· Average weekly hours, manufacturing
· Average weekly initial claims for unemployment insurance
· Manufacturers’ new orders, consumer goods and materials
· Index of supplier deliveries — vendor performance
· Manufacturers’ new orders, nondefense capital goods
· Building permits, new private housing units
· Stock prices, 500 common stocks
· Money supply, M2
· Interest rate spread, 10-year Treasury bonds less federal funds
· Index of consumer expectations
 
Our Thoughts
Heading into the Aug. 2 debt ceiling agreement deadline, most market participants expected a reasonable resolution to the negotiation and for the market to head higher as a result. Instead, a disappointing agreement led to a U.S. debt downgrade. Additionally, economic and sovereign debt issues in Europe intensified. In just three weeks, the world economic outlook has slowed significantly. Many investors, including us, were caught long.
It’s critical that we trade “what is” rather than “what we want it to be.” It makes us somewhat concerned that many strategists are talking about this correction as short term. Many of these strategists have a vested interest in seeing the market recovery, which may be affecting their viewpoint.
It’s necessary to keep emotions out of our thinking. That’s why we rely on market signals that have worked for decades. When we look at our market sentiment indicator below 10%, the VIX well above 40, Leading Economic Indicators on the rise, strong stock yields and heavy insider buying, our belief is that the equity market is oversold.
Unfortunately, it’s likely we haven’t yet seen the worst of the economic data or the worst of the news regarding the eurozone sovereign debt problem. As a result, the near term is highly uncertain, and we recommend keeping our trading activity to a minimum. As for our open positions, we think it’s best to hold them for now.
At some point in the near term, we’ll have an incredible buying opportunity. Even with the market under pressure this month, most of us probably wish we had put more money to work in March 2009. The good news is, the market often gives us a second chance.
 
TONIGHT: Please Join Us for a Live Q&A
Our next Big Money Options educational Trading Session Workshop is TONIGHT at 6 p.m. ET. We’ll join our colleague John Jagerson for a live Q&A session. These live sessions are a great opportunity for you to ask us your trading questions.
We know the market has been turbulent and our positions have taken a beating. Rest assured that we’re still here, monitoring our trades and looking for new ones with the strongest institutional signals. We encourage you to attend the live session TONIGHT at 6 p.m. ET so that you can ask us anything you want to about this service, our trades, our methodology or the market in general.
We want to hear from you. We like to know what you’re thinking. So please join us live TONIGHT at 6 p.m. ET. Sign up now by clicking here. You’ll receive an e-mail reminder before the live session.
 
REVIEW OF TRADES/POSITIONS
All of our open positions were severely damaged by the market crash of the past two weeks. Given the dramatic price decline, we have moved all positions to “hold” and would not add new money to our existing positions with the exception of our Ford (F) combo recommendation, which we made last week.
We plan to take advantage of the newly developed market conditions to initiate new trades. For the moment, options buyers mostly have been attempting to hedge their long stock. Given last week’s crash and the market volatility, it has been difficult to decipher any meaningful trading patterns in stocks or options.
The panic will abate, and it should become evident whether we’ll see a strong market bounce or the continuation of a negative price trend. In either event, our plan is to put on new trades that take advantage of the new pricing environment.
The full details of each trade are shown on the Big Money Options website.
 
Positions Opened
Ford (F) — On Aug. 17, we recommended you ‘buy to open’ the F Jan 2012 12.50 Calls (F 120121C00012500for 65 cents or less, and simultaneously ‘sell to open’ the F Jan 2012 10 Puts (F 120121P00010000) for 75 cents or more, for a net credit of 10 cents or more. In this highly volatile market, prices are moving quickly, and the market fell to its lows by Friday. At market close on Friday, you could have opened this trade for an 82-cent credit. We like F, and we continue to like this trade.
 
Positions Closed
— NONE —
 
Top Trades Now
Ford (F) — See Positions Opened above.
 
The remaining open trades are:
Amkor Technology Inc. (AMKR) — On July 7, we recommended you open a bullish combo on AMKR by “buying to open” the AMKR Sep 7 Calls (AMKR110917C00007000) for 40 cents or less, and simultaneously “selling to open” the Sep 6 Puts (AMKR110917P00006000for 40 cents or more, for a zero net debit. As with the majority of our current trades, we’re placing a ‘hold’ on this position for now.
Commercial Metals Co. (CMC) — On July 27, we recommended you “buy to open” the CMC Sep 16 Calls (CMC110917C00016000for 40 cents or less. At market close on Friday, this position was 5 cents. Hold; don’t add fresh money.
Force Protection (FRPT) — On May 16, we recommended you “buy to open” the FRPT Dec 4 Calls (FRPT111217C00004000for $1.30 or less. We paid $1.35. At market close on Friday, the position was 35 cents. Hold; don’t add fresh money.
Leggett & Platt (LEG) — On June 21, we recommended you”buy to open” the LEG Sep 25 Calls (LEG110917C00025000for 70 cents or less, and simultaneously “sell to open” the LEG Sep 22.50 Puts(LEG110917P00022500for 75 cents or more, for a net credit of 5 cents or more. Let’s continue holding for more favorable conditions. Don’t add fresh money.
SBA Communications (SBAC) — On July 7, we recommended you open a bullish combo on SBAC by “buying to open” the SBAC Sep 40 Calls (SBAC110917C00040000for $1.65 or less, and “selling to open” the SBAC Sep 40 Puts (SBAC110917P00040000for $1.60 or more, for a net debit of 5 cents or less. The options are way out of range, so it’s best to hold this position.
Staples (SPLS) — On March 9, we recommended you “buy to open” the SPLS Sep 22 Calls (SPLS110917C00022000) for 90 cents or less.The company issued disappointing earnings guidance, crushing the stock. At market close on Friday, this position was 5 cents. Continue to hold.
Telefonica (TEF) — On June 27, we recommended you either go long by “buying to open” the TEF Dec 25 Calls (TEF111217C00025000for 95 cents or less — OR — open a bullish combo by “buying to open” the TEF Dec 25 Calls (TEF111217C00025000) for 95 cents or less, and simultaneously “selling to open” the TEF Dec 20 Puts (TEF111217P00020000) for 80 cents or more, for a net debit of 15 cents or less. At market close on Friday, the long TEF Dec 25 Calls were 25 cents, and the combo offered a $2.35 credit to open, but now isn’t an ideal time to commit money here. Continue to hold.
Tellabs (TLAB) — On April 29, we recommended you “buy to open” the TLAB Jan 2012 5 Calls (TLAB120121C00005000for 65 cents or less.At market close on Friday, the position was 15 cents. We continue to see bullish options flow in TLAB. The company has about $3.50 per share in cash, which should limit further downside. Let’s wait and see how this unfolds.
USEC Inc. (USU) — On Nov. 16, we recommended a bullish risk-reversal on USU by “buying to open” the USU Jan 2012 7.50 Calls (USU120121C00007500) for 70 cents or less, and simultaneously “selling to open” the USU Jan 2012 5 Puts (USU120121P00005000for 95 cents or more, for a net credit of 25 cents or more. We entered the trade for a 30-cent credit. At market close on Friday, the calls were 5 cents, and the puts were $2.90. With the stock trading below our put strike, we don’t recommend adding new money to this trade.
 
Parting Shot: An Old Favorite
In 2009, when the economy was moribund, traders used to talk about the action in the Baltic Dry Index. It’s often cited as a bellwether of global economic activity. This index was up 16% last week.

Source: Bespoke Investment Group
 
Even this volatile, short-term index says “no recession.” It appears that if banks don’t implode, the market could bounce surprisingly fast.
 
Have a great week trading,

Nick Atkeson and Andrew Houghton
Editors
Big Money Options

 

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