Forget the Super Bowl, let’s talk about Super Stocks. As excited as we are that are hometown team (San Francisco) made it to the Big Dance and fought admirably, we are even more excited stocks are breaking out to new highs. The Dow traded and closed above 14K for the first time since October 2007 and is less than 1.5% from an all-time high.  Although the S&P 500 is also at the highest level since Oct. ’07, the broader index has roughly 4% to climb before reaching all-time highs.  The NASDAQ which is still 38% below its 2000 tech bubble high is at the highest level since Oct. ’00.  February looks to keep the pace with a strong first day. Do stocks have your attention yet?

The answer is yes, sort of. Investors poured money into equity mutual funds at the fastest clip since 2000 explaining a large portion of the stock market’s 5% January advance. Inflows at the start of the year are common.  This year, however, there was significant and unusual pent-up demand as investors had gone to the sidelines in droves anxious how Washington would handle the fiscal cliff. Not only were investors on the sidelines, many had hedged their long positions with puts or even shorted stocks. The unwinding of the puts and covering the shorts provided the extra boost.

We say “sort of” because stock investing has not been in vogue and one month hardly makes a trend. After the beating in 2007-2009, many individual investors have shunned stocks and/or are weary of them. The S&P 500’s 51% top-to-bottom drawdown is still strong in memories.  As stocks more than doubled off the lows, the volatility in 2010, 2011 and 2012 did little to soothe fears.  The problems in Europe and Washington are real and significant, but the steady fuel from the Fed, a housing recovery that finally has substance and a strong credit market make us confident the wind is at the back of stocks.

As confident as we may be, we are humble enough to know the only constant is change and one cannot get stuck in one’s ways. Big Money Investing is all about staying disciplined, tactical and trade without emotion. If the market is turning for the worse, a more defensive positioning will be deployed.

Market Sentiment Indicator

One of our favorite indicators is a simple 75-day moving-average crossover. We have found with over 40-years of data that when more than 50% of a large group of stocks (we follow roughly 3,600) are above their 75-day-moving average, the market is bullish. On the flipside, when less than 50% are above, the market is bearish. The number turned bullish early December and is 82%.  On average, bullish cycles last 22 weeks.  

The #1 question is “with the indicator above 80, isn’t the market overbought/extended and shouldn’t we be taking profits?”  The market is more overbought than not. The 75-day MAC is an intermediate term indicator. When looking at the shorter terms indicator, we like to look at the 10-day MAC, This number is 69%.  This is rich but not overbought. A number closer to 90 signals the market is short term overbought.

Review of Positions

Electronic Arts (EA) – On Dec. 12, we recommended to buy to open the EA Mar 17 calls (EA 130316C000017000) for $0.55 or better.  The stock was up roughly 10% last week on a solid earnings report. As of Friday, these options closed at $0.36. 

EMC (EMC) – On Jan. 10, we recommended to buy to open the EMC April 25 calls (EMC 130420C000025000) for $0.95 or less, As of Friday’s close, these options closed at $0.93.  The stock gapped down on earnings but is quickly filling the gap. We continue to like this trade. Earnings are scheduled for Jan. 29.

Lilly (Eli) & Co. (LLY) – On Jan. 9, we recommended to buy to open the LLY July 55 calls (LLY 130720C000055000) for $1.45 or less, As of Friday’s close, these options closed at $1.69. We continue to like this trade.  The stock reacted well to earnings.

Thomson Reuters (TRI)  On Jan 16, we opened a position in the TRI Jul 30 calls (TRI 130720C000030000) for $1.60 or less.  As of Friday’s close, this position was $2.00.

Parting Shot:  It is about risk premium, not earnings

As we just witnessed one more time, individual stock volatility during earnings season can be quite extraordinary.   Some of our positions had some big moves off their reports. So, when we say stocks are driven by risk premium and not earnings, you may ask what are we talking about.

In the year 2000, earnings for the S&P 500 were roughly $56 and the index was at 1,500.  This year, earnings are estimated to be $110 and the index is 1,500.  The P/E essential was cut in half from 27 to 13.5.  Instead of asking what are we talking about, one should be asking what’s the catch.

When investors are risk averse, investors demand more earnings, more safety. When their risk acceptance rises, stocks and P/Es tend to rise.  Before the third quarter earnings season, earnings for the fourth quarter were estimated to be around 8%. This estimate was quartered before the fourth quarter earnings season began. Surprisingly, stocks are reaching new highs. On Friday, roughly 20% of the 3,600 stocks we follow were at 52-week highs.

We are respectful of momentum and history (and risk premium), so we want to continue to ride the trend. At the same time, we realize complacency is killer.  All senses are on full alert as we get deeper into overbought territory and ride this bull wave. 

Have a great week trading,

Nick Atkeson and Andrew Houghton

Editors
Big Money Options

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