Up until Friday, the Dow Jones Industrial Average (DJIA) had closed higher 10 straight trading days in a row and had climbed 485 points during this time. On Friday morning, former Fed Chairman Alan Greenspan said there is no “irrational exuberance” in equity markets and stocks are “significantly undervalued.” All of the major U.S. stock indexes closed down on Friday. Let’s hope that Greenspan is not once again the kiss of death.
With the markets near all-time highs, you might be wondering what the pros are doing with their money. Generally, what the pros do in strong trending markets is ride the trend to the end. There is nothing better for most investment professionals than a trending market. Many keep on buying with every new up-tick.
One of the biggest mistakes non-professional investors make is the mistake of anticipation. As the market rises, less experienced investors tend to become increasingly anxious. Every down-tick looks like the beginning of the end. Out of fear the market has reversed trend, they sell out of the rally. Almost always, this early move takes them out of a trend way too early. The market continues to move higher and they never re-enter as their cognitive dissonance creates a buying block.
We can say with virtually 100% certainty that the current bullish trend will end. We just can’t say exactly when. What we do know is not to try and anticipate the end. Let the market tell you the trend is over. Markets almost always overshoot both on the upside and downside what most investors would expect to be reasonable price movement. In our case, we will stay invested until our market sentiment indicator turns bearish. Until then, we are bullish.
If you are looking for reasons why the market may continue to trend higher, some of the more interesting viewpoints that have arisen lately include:
- The feared job cuts caused by sequestration appear to be significantly overstated. 75% of the cuts are expected to come from furloughs and not actual cuts in employment. Furloughs in the private sector will be felt in falling workweek and not job totals. 80% of the job cuts will be in government employment, most of which will be furloughed.
- Political compromise on entitlement reform (where the bulk of the deficit spending problems resides), may come naturally as citizens work longer. Wage stagnation of the past decade and loss of savings during the recession may force many Americans to delay retirement. Delayed retirement leads to delayed drawdown of Social Security and potentially an opening for politicians to formally raise the age by when benefits are vested.
- With people buying new cars at a rapid clip, U.S. vehicle fuel economy posted the biggest one year gain in 2012 since 1975 (right after the first oil crisis when small, Japanese cars became more popular). Fuel efficiency reduces the impact of fuel price volatility on the economy and often helps improve standard of living growth.
This morning, financial instability in the Cyprus banking system is giving investors a buying opportunity. Equity investors are concerned about a plan to tax bank deposits in Cyprus. Under the EU plan to bail out Cypriot banks Cyprus will impose a levy of 6.75 percent on deposits of less than 100,000 euros and 9.9 percent for 100,000 euros or more. This is a break from the normal EU depositor protection scheme where the first €100,000 was protected. But the EU deposit protection is administered at the national level – and the Cypriot government does not have adequate funding to offer that protection. So the worry is that deposits may flow out from weak banks in countries with overly indebted governments. But, provided the ECB continues to supply funds to these banks, and banks are seen to be adequately capitalised, an EU-wide credit crunch appears unlikely.
On Wednesday, Fed Chairman Bernanke is expected to issue a statement post the FOMC meeting saying the economy is gaining traction but the Fed will continue to maintain its current easy money policy until employment conditions significantly improve.
On April 8, Alcoa (AA) will report earnings and official commence the earnings reporting season. Between now and then, we will see preannouncements. The preannouncement surprises will likely provide a lift to volatility and we would not be surprised to see the VIX rise from its 11.30 Friday close. On the Greek bank news this morning, the VIX climbed 17% near the open to a high of 13.52. Almost immediately, the market recovered from its lows as buyers used the weakness to put more money to work. We would use downside volatility as a buying opportunity as the intermediate trend remains bullish.
Review of Positions
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 $0.77.
Healthcare Trust of America (HTA) – on Feb 13, we recommended you buy to open the HTA Jul 12.5 calls (HTA 130720C0000125000) for $0.45 or better. On Friday, this position closed at $0.50.
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 $1.72.
Charles Schwab (SCHW) – On Mar 7, we recommended to buy to open the SCHW Sep 18 Calls (SCHW130921C000018000) for $1.05 or less. As of Friday’s close, these options closed at $1.00.
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 $2.70. We continue to like this trade.
Parting Shot: Market Sentiment Indicator
Shown below is our MSI (blue line) superimposed on the equal weighted S&P 500 measured by the ETF (RSP). We are bullish on the stock market when the MSI is above the 50% market and bearish when it is below.
The scale for the MSI is on the left hand y-axis. The MSI increased from 73.2% to 76.7% last week. The market remains bullish in the intermediate term and is not showing signs of being significantly overbought. We continue to recommend buying on weakness.
Have a great week trading,
Nick Atkeson and Andrew Houghton
Big Money Options