“And Now Here’s Something We Hope You’ll Really Like!”

Dear SlingShot Trader Subscriber,

For anyone who didn’t grow up on sugar-fueled Saturday morning cartoon-watching marathons, the title of this week’s update is Rocky the flying squirrel’s response to Bullwinkle’s latest weekly attempt (while pretending to be a magician) to pull a rabbit from his hat. Quite often what actually emerged from his hat was a roaring lion rather than a rabbit. The market is playing out its own version of The Rocky and Bullwinkle Show right now, which can be a little disruptive for investors.

The Bullwinkle in the market right now is the Federal Reserve. The Fed thinks it can pull another stimulus rabbit from the hat, but what we might get instead is roaring inflation. Besides inflation, it’s uncertain whether monetary policy (what the Fed does) actually can do very much to affect the markets in the long term. In either case, it’ll take some time for Rocky, or real traders, to get a handle on what really happened and how they believe it will affect prices in the long term.

While investors come to grips with the latest trick of the Fed, we expect volatility to rise. We expect this because although the intentions might be good, a side effect of Fed intervention is to obscure critical information from investors. Hidden information leads to uncertainty and wide price swings up and down. Unusually high volatility isn’t a good sign for the market (see last week’s update), so we’re still biased to the downside for now. This makes option trading a little risky, but it also can increase the potential rewards. Wild markets shouldn’t be avoided — they just need to be managed.

 

The Fed Has Obscured the Relationship Between Stocks and Interest Rates

Through monetary policy, the Fed can do a lot to manage interest rates on corporate and government bonds, mortgages and deposits. The Fed is determined to keep rates low through next year and may try to manipulate portions of the yield curve (the so-called “Operation Twist”) to create an incentive for investment in the economy by businesses and banks. However, this intervention also increases uncertainty because it hides information about interest rates that investors need to make decisions.

We’re regularly asked about the relationship between interest rates and the stock market. In a normal bull market, rates will rise with stocks and vice versa in a bear market. However, because the Fed has been pushing rates down artificially, no one can analyze that normal relationship with any confidence. In the chart below, you can see how rates on the 10-year Treasury bond (red and green candles) and stocks (black candles) relate to each other.

Chart courtesy of Metastock Professional


We used rates on the 10-year Treasury bond because it tracks mortgage interest rates and deposit rates very well. Interest rates and stocks tend to follow each other because they’re both affected positively by growth expectations. However, they will diverge when stocks become overbought, such as they did in 2007 when the housing market really started to decline. As you can see, the delta between the two indexes is even wider right now, with rates at a record low.

The current divergence between interest rates and stocks typically would be a very bad sign for stocks, but right now it’s difficult to tell the difference between the natural movement of the market and the intervention by the Fed. When traders don’t have all the information they need because the Fed is intervening in the market, it can make them jumpy — and that jumpiness will lead to large, short-term corrections.

 

Rabbits or a Lion: Does It Matter to Us

You should take two things away from this week’s update. First, no one really knows how the Fed will affect the market following its announcement later today. We do know that intervention can make decision-making more difficult for longer-term investors because it hides information they need, which leads to volatility. Second, volatility traders may prefer a strong trend, but here at SlingShot Trader, we can profit in either market.

The difference for volatility traders like us in an uncertain market is that our risk/reward and win/loss ratios change. In a trending market, the win/loss ratio is much higher, but the reward dips a little. That’s an acceptable trade-off for most investors. In a market like the one we’re in now, the win/loss ratio can drop, but big moves are more likely, which can make winners much larger.

Theoretically, each situation should more or less even out, however, the X-factor in this kind of market is emotion. To profit in this market, we have to deal with how we feel about our trades — not just what the numbers look like. We aren’t suggesting that we engage in some kind of trader primal-scream therapy (although that seems to help some days). What we really need to do is to have a discussion about how to set expectations. Being prepared for volatility and understanding what’s causing it helps us deal with it more effectively.

In today’s live webinar, we’ll discuss those issues in more detail and also show you how we’re looking for trades in the near term. We’re quite optimistic about the next several weeks, regardless of what the Fed does, and we hope you will be, too. Please plan to join us tonight at 6 p.m. ET. If you can’t attend live, you can watch the archived webinar online later this evening.

 

This Week’s Events

Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

9/22 — Finish Line (FINL) earnings report, after market close

9/23 — ECB President Jean-Claude Trichet speaks

9/26 — U.S. New Home Sales report

9/27 — Walgreen Co. (WAG) earnings report

9/27 — U.S. Financial Consumer Confidence report

9/28 — U.S. Durable Goods Orders report

9/28 — Family Dollar Stores (FDO) earnings report

 

The Bottom Line for Next Week

The real market-mover for the coming week will be the Fed’s FOMC announcement and the reaction to it. However, there are other key news releases from the list above to which we’re paying close attention.

We are between earnings seasons, so the announcements from individual stocks will remain light until Alcoa (AA) announces Oct. 11, kicking off the third-quarter reports. In the meantime, we’re watching reports from retail stocks such as Walgreen (WAG) and Family Dollar (FDO) as leading indicators for consumer sentiment and corporate profits.

When corporate news gets light, traders pay a lot more attention to economic reports, and we’re expecting a strong reaction to next week’s consumer sentiment numbers, released Sept. 27. The U.S. stock market will rise and fall with consumer sentiment and spending, which means a negative surprise could push stocks much lower. This report, combined with the trickle of retail earnings reports, should help us plan for positioning in October.

 

TRADE REVIEW

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.

 

Positions Opened

Finish Line (FINL) — On Sept. 20, we recommended you to “buy to open” the Oct 20 Puts for $1.45 or less. We still like this trade.

 

Positions Closed

Adobe Systems (ADBE) — On Sept. 16, we opened the Oct 24 Puts for 99 cents. After the company surprised slightly to the upside following its earnings announcement yesterday, we recommended you “sell to close” the puts at market earlier today. We closed the position at 63 cents.

 

Top Trades Now

Finish Line (FINL) – See Positions Opened above.

 

Webinar Preview: Join Us Tonight at 6 p.m. ET

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 johnandwade@slingshot-trader.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
Editors
SlingShot Trader