Dear Slingshot Trader Subscribers,
Like every other analyst, we can’t skip discussing yesterday afternoon’s Alcoa (AA) report, but news like this can seem confusing on the surface. Earnings are down 64% since the same quarter last year with flat revenues, and yet the stock’s price is up more than 8% this morning. Of course, no matter how bad the actual numbers are, expectations were slightly worse, which is the ultimate cause of the rally this morning.
The benefit of lowered expectations
Yesterday’s report was the perfect alignment of factors for Alcoa. The market has been selling off aggressively, expectations were very low, and the report was ‘less bad’ than most analysts hoped. However, we are definitely not ready to get on the bandwagon of investors and analysts making the argument that this is the turning point for stocks to continue the rally.
Alcoa sometimes has a disproportionate impact on market prices, because it is the first Dow Industrial Average component to report each season. The next one on the list is JP Morgan (JPM), reporting Friday morning, followed by Coca Cola (KO), Johnson and Johnson (JNJ), IBM (IBM), and Intel (INTC) all reporting next Tuesday. One question we might want to ask right now is whether expectations for these stocks have also dropped significantly, and therefore the potential for a surprise has been increased?
The short answer is yes and no. Expectations across the board are very low – in fact, they haven’t been this low in a few years – but they are low for a reason. Some investors are looking at this as evidence that there is a lower risk of disappointments because analysts are sandbagging their expectations. The other way to look at it is that any misses this season (when the bar is so low) will have a disproportionately negative impact on the market. We are strongly leaning towards the latter scenario as more likely.
Investing patterns are diverging
What is the evidence for such negativity? Let’s review the list – job growth is flat, GDP growth in the U.S. and China is declining, bonds are still at record highs, oil inventories remain surprisingly high, and Europe’s economy is actually in contraction. Let’s just consider that last issue; the Eurozone is the second or third largest economy in the world, depending on how you work the numbers, and they are actually in contraction. That issue has led to one of the most dramatic divergences we have observed in some time.
In the next chart you can see the S&P 500 (black and white) versus the popular Spain-based ETF from iShares (EWP – green and red candles) graphed over the last four years since the post-Lehman collapse of 2008. These two indices tend to follow each other quite closely in the long term, however, in the last three years they have broken that correlation a few times when U.S. equities grew out of pace with risk expectations.
While it doesn’t happen 100% of the time, the bias when these two diverge is for the U.S. market to correct in favor of Spain. Does this mean the kind of crash we saw last August will happen this quarter as well? Probably not, but it certainly adds weight to the argument that U.S. equities have become seriously overbought and are due for a deeper draw-down than we have seen over the last three weeks.
There is actually a long list of divergences that have been at play during the rally in large-cap U.S. indices over the last few months. Bonds, small-cap stocks, oil prices and transports have all been warning for a decline for a long time. After a while, traders started to legitimately start to wonder when these breaks will reconcile or if they ever would.
Preparing for earnings
As short-term investors, we can’t get too caught up in what we think the market should do versus what it is actually doing, but we also shouldn’t ignore the signals of structural conflict either. This means that we plan to continue with a mild bias to the downside, while still seeking out a few trades that look seriously undervalued before earnings or economic reports. A two-to-one bearish to bullish ratio in our trades sounds about right as we head into this earnings season looking for new opportunities.
The bottom line for this week
We are expecting frequent large price moves, following surprises and misses like this morning’s Alcoa reaction, over the next few weeks. Expectations have been very volatile, but because volatility is still quite low, option prices are mostly under control, which is in our favor. We expect our trading volume will be higher than average as earnings season really gets kicked off next week, and we are excited about the potential profits over the next few weeks.
This Week’s Events
Apr. 12 – Chinese GDP & U.S. Trade Balance
Apr. 13 – U.S. Inflation & Consumer Sentiment Data
Apr. 13 – Wells Fargo (WFC) & JP Morgan (JPM) Earnings
Apr. 16 – U.S. Retail Sales & TIC Data
Apr. 16 – Citigroup (C) earnings
Apr. 17 – TD Ameritrade (AMTD) & Intel (INTC) earnings
When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here. You can also see more trade-specific details by clicking on the trade links below.
These are the SlingShot Trader positions we opened during the past two weeks of trading that we have not yet closed.
TD Ameritrade (AMTD) – On April 10th we recommended you to “buy to open” the May 18 puts for $0.40 or less. On April 11th we updated this recommendation with a higher acceptable entry price of $0.45 per share. We still like this trade and recommend entries at our maximum price or less.
Intel (INTC) – On April 11th we recommended you to “buy to open” the May 28 calls for $0.80 per share or less. We still like this trade and recommend entries at our maximum price or less.
These are the SlingShot Trader positions we closed during the past week of trading.
Manpower (MAN) – On April 10th we recommended you to “sell to close” the May 45 puts. We closed the position for $2.95 per share for a gain of 70%.
Alcoa (AA) – On April 9th we recommended you to “sell to close” the May 10 puts. We closed the position for $.66 for a gain of 47%.
iShares 20+ Treasury Fund (TLT) – On April 9th we recommended you to “sell to close” the April 111 puts for $.93 per share for a loss of 51%.
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Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.
And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at email@example.com.
If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.
John Jagerson and Wade Hansen