Both the stock market and Treasury market have been rallied in the past few weeks on a somewhat divergent view of the economy, but sooner or later, I think something has to give, and I think it’s likely going to be stocks.
I don’t think the upward trend in stock indexes is finished just yet, but I think investors and traders should be prepared with appropriate strategies once the trend starts to shift. I believe a correction is in store for the stock market.
The latest quarterly corporate earnings reports have helped boost stocks, but companies have exceeded relatively low expectations. Some market participants also feel the Fed and/or government will engage in more stimulus measures to boost the economy. What you get with more stimulus is more free money, and that should drive stocks higher—at least temporarily. But the fact that the Fed and government may feel we need more stimulus means the economy is still in bad shape, and we keep digging ourselves deeper into the hole.
Treasury prices have moved higher and yields lower on the idea the economy is worse than thought—and could even fall back into recession. The yield on the 10-year Treasury note hit a 15-year low this week, at 2.81 percent. I think the Treasury market’s more dim view is likely to prevail, and major stock indexes will correct back.
The July employment report was a disappointment. The initial stimulus measures haven’t worked as well as hoped, and the unemployment rate has stagnated at 9.5 percent. The Bush-era tax cuts are up for expiry, and that development is not likely to be taken as positive by market participants.
At the conclusion of the FOMC meeting August 10, I think Federal Reserve policymakers will likely temper their recovery expectations based on recent economic data, mainly the jobs report. The stock market has been inching higher in the past few months, so there is likely no real need for the Fed to venture too far off the course it has been on. The Fed is likely to stick to their current course of action, but will also likely give the message that everything is not going to be perfect by tomorrow.
Market participants expect the Fed to keep its key short-term interest rate (known as the Fed funds rate) target steady at 0 – 0.25 percent, where it has been since December 2008. CBOT Fed funds futures are not pricing in meaningful odds of a rate hike until June 2011.
Trading Strategy
Investors anticipating a correction this fall might consider purchasing S&P 500 puts, or a put spread. Options are relatively inexpensive right now, because volatility is low. But a move lower could be significant. I wouldn’t be surprised to see the market break 1,000.
You might consider the November 1,100/1,000 put spread (buying the 1,100 put and selling the 1,000 put), or the 1,060/960 put spread, depending on your objectives and risk tolerance.
An attractive aspect of this type of trade is that when the market falls, it injects fear into the market, and options prices will increase. That means the premium moves in your favor, and your risk is defined. You get a good bang for your buck if you buy puts as a hedge. You could buy first leg of the spread, then if and when we catch a move, you can leg into the other side of the trade if you wish. You could buy the 1,100 now, then sell the 1,000 put later.
Bill Dixon is a Senior Market Strategist with Lind-Waldock. He can be reached at xx or via email at bdixon@lind-waldock.com.
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