We have been resisting the urge to short the US stock market all year for 3 reasons: 1) the market is in an uptrend; 2) low global interest rates mean stocks are still the only game in town and; 3) we’ve seen so sign of the euphoria that usually accompanies a stock market top. However today’s negative price action (the S&P is down over 1% as we write this) has us a bit spooked. If this down-move holds, it will be the first time the market has failed to follow through on a big recovery day this year.
But that’s not the only thing that’s making us nervous. The market is coming awfully close to taking out its short-term uptrend line. (See chart above.) A series of lower closes beneath the key 2030 level in the E-mini S&P 500 futures contract would be extremely negative. This could happen as early as the close today or the opening Monday morning.
There are also worrisome fundamental factors at work. The strong dollar is hurting US competitiveness overseas. US corporate profits are expected to fall 4.6% in the first quarter of this year and another 1.6% in quarter number two. Absurdly low interest rates are enabling corporations to borrow like crazy, but they are not using the funds to increase productivity or augment their businesses. Instead they are using it to buy back their own stock.
According to David Stockman, Director of the Office of Management and Budget under President Ronald Reagan, the amount of new money flowing into the market from companies buying back their own stocks exceeds that of ETFs and speculators by a ratio of 6 to 1. That means stocks are rising largely because of financial engineering. This is why the market has been so volatile lately. A Fed rate hike would increase the cost of money and remove much of the fuel feeding the bull. Success or failure is now almost totally Fed-dependent. This makes the current market environment extremely fragile.
Negative Interest Rates Are An Ominous Sign
Now running 6 years, the current bull market in stocks is also a bit “long in the tooth.” It has also been one of the strongest bull markets on record. The current gain of 206% from its 2009 low is twice the historical average.
But the thing that really concerns us about this market is not its length or strength but the current psychological environment. Investors – supposedly smart investors – are eagerly accepting negative interest rates for the first time in the 5,000-year history of markets – thereby guaranteeing themselves small losses in exchange for the illusion of safety. This is frightening.
If investors are willing to do this with their supposedly “safe” money, what will they do when the next “dip’ in the stock portion of their portfolios is not followed by new highs but by another, bigger “dip?” Spring may be in the air but what we are smelling in the global marketplace is not the scent of flowers but fear. In this age of high frequency trading when nearly every move seems to be exaggerated, a stock “correction” could easily pick up speed and become a bear market in the blink of an eye. Just look at what has happened to the euro.
Then there is the Fed…
The question is not “if” Janet Yellen and Company are going to raise rates but “when.” Since the current bull market is largely the result of Fed action – or inaction– it makes sense to assume that the first rate increase will not be greeted well by the stock market. Yes, the economy is getting stronger, but the stock market in a leading indicator. A strong economy is already built into stock prices. There have been plenty of instances when stocks have fallen during an economic boom.
So do we go out and liquidate everything? Absolutely not. The trend is still up. But we can be proactive. Options give us the ability to buy some protection. We can do this relatively inexpensively despite today’s elevated volatility using a professional trading strategy called a “butterfly.”
We are targeting a drop below the long term uptrend line, currently crossing at 1950 in the E-mini futures contract – roughly 4.5% lower than current levels. We believe stocks could drop as much as 17% from recent closing highs (2113) rather quickly should this level get taken out. The September “butterfly” strategy we are currently recommending has a total cost and risk of $1,200 plus transaction costs with the potential to be worth as much as $10,000. September options do not expire until September 18, 2015.
Prices can and do change so check with your personal RMB Group broker for the latest on this or alternative protective strategies and to get up-to-the-minute pricing and advice. If you don’t have an RMB Group trading account and would like to know more about this or any other “Big Move” strategy, call 800-345-7026 toll free or 312-373-4970 direct. You can also email email@example.com or visit us online at www.rmbgroup.com.