Where Is the Money Really Flowing?

Dear SlingShot Trader Subscriber,

Europe, Shmeurope. Isn’t everyone tired of hearing rumors and speculation about the debt crisis? I suspect you are, but how that crisis unfolds is likely to set the theme for the rest of 2011 and early 2012. In fact, the rally over the last few weeks probably was partially supported by a steady stream of news that European leaders are “working” toward a long-term solution. (A very strong start to third-quarter earnings season didn’t hurt, either.)

Whenever we’re faced with a situation like the one in Europe, where headlines shift between “the sky is falling” and “all is well” on a daily basis, we start to ignore the news and investigate whether there’s a real shift in assets that would indicate a change in market fundamentals. In other words, “money talks.” Stock prices can help in that respect, but equities are actually a relatively small market compared with total international capital flows, so they provide an incomplete picture.

In this week’s update, we’ll walk you through what the two largest capital markets are saying about the crisis and the chances of a new bull market.

We hope to help everyone understand why our track record is up more than 36% since inception in April while the S&P 500 (SPX) is down 6%. Digging into the details behind the news is what has kept us profitable since the beginning of the third-quarter crash this past July. Investing is never perfectly smooth, but being willing to stick with our analysis has paid off with profits. Like you, we refuse to be victims of the erratic behavior of central banks, rating agencies or financial journalists. We’re glad to be in good company with you.

 

The 900-Pound Gorilla: The International Currency Market 

More value is traded on a daily basis in the currency market (Forex) than trades on the U.S. stock exchanges in an entire year. This is where the official sector (central banks and governments) are most active, and it’s heavily traded by banks, multi-national corporations and fund managers 24 hours a day. Because of all this activity, the currency market is the best window into investor sentiment and confidence.

Like most markets, the Forex has been suffering from an unusual amount of artificial intervention this year, but those actions can only obscure supply and demand to a limited extent. Right now, we’re paying attention to the safe-haven currencies that attract investors when they become very fearful. Those include the Swiss franc, Japanese yen and the U.S. dollar, among a few others. Traders will move in or out of these currencies at different rates, depending on how difficult things get in the global economy.

A great way to get an insight into investor fear is to compare a safe-haven currency with one that’s at risk. In the next chart, we’ve compared the euro to the Japanese yen. Next to the U.S. dollar, these are the two largest reserve currencies in the world. The downtrend means that the euro has been losing value compared with the yen. This isn’t because of relative economic strength; the Japanese economy is a complete mess. The real issue here is that large investors are getting rid of euro-denominated assets in favor of yen-denominated assets as a hedge against uncertainty in the eurozone debt market.

EUR/JPY Daily Chart Courtesy of Metastock

 

The downtrend we can see in this chart actually has been in place since 2008 and just missed hitting a 10-year low early this October. The recent rally when the euro began gaining a little has been encouraging, but it’s well within normal volatility limits. What this tells us is that Forex investors remain unconvinced that economic growth will accelerate or that risk in the eurozone has been abated.

The picture is very similar with other currency pairs. In fact, the hedging has been so severe during the last few months that the Swiss actually did the unthinkable and pegged their currency to the euro, effectively turning over monetary policy to the European Central Bank. If/When that peg is lifted, or these safe-haven trends change, then we’ll become much more confident about the long term.

Those of you who have been with us for a while know that we don’t just trade stock options. We periodically buy options based on currency fluctuations. Those trades have been nicely profitable on average, and we expect to continue to improve performance in those trades in the future.

 

The Other 900-Pound Gorilla: Bonds

The bond markets are a great place to get additional insight into risk because it’s virtually all bond traders care about. If anticipated risk rises, it will show up in bond prices and yields. To understand how we look at the bond markets to measure risk, just imagine that you live in a neighborhood where everyone needs a mortgage, but your neighbors’ credit ratings vary. Your next-door neighbor who is underwater in his home probably will have to pay a much higher interest rate than your neighbor across the street who has 50% equity in her home and a high-paying job. That difference in interest rates can be called a “yield spread.” The wider the spread gets, the more concerned lenders are about your struggling neighbors.

Government debt is similar to home loans in many ways. For example, lenders are virtually unwilling to loan to Greece — and they’re becoming more reluctant to loan to Spain, Portugal, Ireland and Italy because those countries are “underwater” already and might not be able to pay their current debt. Even France has been recently downgraded and is struggling with higher yields.

The “good neighbor” in Europe right now is Germany. The bailout deal in Europe is a bit like the good neighbor being willing to co-sign on all the other mortgages so the neighborhood won’t go into decline due to foreclosures. The spread between German and other European debt is quite wide — and getting wider.

For example, in the chart below, you can see the difference between the yields (interest rates) on German 10-year bonds versus the yield on Italian 10-year bonds. Despite the rally in stocks during the last few weeks, bond traders still feel like risk is as high now as it was when the market crashed in early August. If traders think the credit markets are still at risk, they have a tendency to dump other high-risk investments as well, such as stocks.

10-year Bond Yield Spreads – Bloomberg

 

How Do Currencies and Bonds Affect Stocks?

We wanted to go into detail on these two large markets because they provide more detail than looking at the resistance break on the S&P 500 this week. Fear is still very high — and that can spread quickly to stocks. Before we can get too confident about a new bull market, we have to see significant changes in the markets that dominate the capital markets globally. If we were to simply follow the day-to-day movement in the stock market, we wouldn’t be sitting on a comfortably profitable track record right now.

None of this means that stocks are doomed. Frankly, we’re pretty stoked that earnings have been so strong. But these signs are just the proverbial green-shoots — not evidence of a longer-term shift in sentiment. If bond yields and currency rates continue to show fear, we would anticipate that the potential for another decline (i.e., a fake-out) in stocks will continue to be very high.

This is not the easiest market to trade — but it is possible. For example, since the market crash in August and the subsequent channel, we’ve had a 50% profitable trade ratio, and our winners have been larger on average than our losers. That is the key to being a successful volatility trader. Traders who have been with us since we started are profitable while the rest of the market is down. We expect to be able to continue doing that (and much better) in the short term by digging in behind the headlines and finding the real opportunities.

 

This Week’s Events 

With earnings season well underway, the schedule is quite busy. The list below covers most of what we’re watching as potential game-changers. We’ll discuss some of these in tonight’s webinar live at 6 p.m. ET.

10/26 — European updates on EFSF status: occurring all day

10/27 — U.S. third-quarter preliminary GDP: before market open (BMO)

10/27 — U.S. pending home sales: 10 a.m. ET

10/27 — Akamai Technologies (AKAM) third-quarter earnings: after market close (AMC)

10/27 — Coinstar (CSTR) third-quarter earnings: AMC

11/02 — ADP non-farms employment change: BMO

 

The Bottom Line for Next Week

Feeling a little on edge is appropriate and reminds us to stay flexible. Although we aren’t ready to call this a legitimate bull-market breakout, we hope we’ve given you a few things to watch for in the future.

 

In the meantime, we’ll continue looking for trades with the most attractive risk/reward ratio on both sides of the market. Volatility will remain high, so plan for wide price swings before the announcements we’re trading actually occur. The good news is that volatility can work in our favor. We need our winners to be large, and that can happen easily when traders are fearful and prone to being surprised in the global markets.

 

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via email. 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 portfolio here. You also can see more trade-specific details by clicking on the stock links below.

 

Positions Opened

These are the SlingShot Trader positions we opened during the past week of trading.

Coinstar (CSTR) – On Oct. 25, we recommended you to “buy to open” the Nov 57.50 Calls for $2 or less. This trade is currently priced near $2, and we still like it for new entries up to our limit price.

Akamai (AKAM) – On Oct. 24, we recommended you to “buy to open” the Nov 24 Puts for $1.60 or less. This trade is currently above our maximum entry price. We don’t recommend it for new entries unless the price pulls back to $1.60.

 

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Corning (GLW) – This morning, we recommended you to “sell to close” the Nov 14 Calls at market. We closed this trade at $1, for a gain of 81%.

 

Top Trades Now

These are the current SlingShot Trader positions that we still recommend getting into now, assuming you haven’t already bought a full position.

Coinstar (CSTR) See Positions Opened above.

CurrencyShares Euro Trust (FXE) – On Oct. 20, we recommended you to “buy to open” the Nov 135 Puts for $2.15 or less. This position can be opened now for a lower price, and we still recommend it for new entries.

 

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