Option Investor
Index Wrap

A bird in hand is worth ....

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If you read last night's Index Trader Wrap, you probably quit reading it halfway down, or simply scrolled to the bottom to get the DAILY pivot levels.

I don't blame you one bit. After I reread last night's wrap, I found my message as being one of uncertainty. As noted in last night's wrap, I DISLIKE option expiration and REALLY DISLIKE Triple Witching expiration week, so I hope those of you taking the time to read tonight's wrap understand where I'm coming from.

So... instead of trying to "interpret" just what the heck happened today as having any type of "economic meaning," then I'm just going to say that my decision in today's market monitor and 01:00 PM EST update (via e-mail) to guard gains in the S&P 500 Index (SPX.X) 1,010 -0.15% was largely driven by the weakness in the financial sectors and noting that S&P 100 Index (OEX.X) 509.65 -0.17% had come so close to testing yesterday's highs and more importantly, this week's WEEKLY S2 (512.44) with a trade at 512.40.

In a way, I found myself asking the question.... is it worth risking 20-points (from Friday's 988 profile) in the SPX, when I'm seeing weakness in financials (roughly 20% of the SPX) just ahead of index expiration, which could bring in some volatility that could have me risking gains at hand, for some type of gain to WEEKLY R2 (1,018.13), or DAILY R2 of 1,019.64?

You've heard the saying "A bird in hand is worth two in the bush," and I decided it best to try and protect the bird in hand instead of going for the "two birds" in the bush (WEEKLY R2, DAILY R1) with the financials showing weakness.

I also believe in the saying ... "when in doubt, get out," and my dislike for option expiration week and Triple Witch expiration, further gave me some reason to exit.

Yes, this seems rather short-term doesn't it? But I'm also having to weigh the HIGH levels of bullish %, which are, in a way, more of a shorter-term to intermediate-term indicator of RISK at this point.

So why did financials lag a bit yesterday and tend to drag on both the S&P 500 Index (SPX.X) 1,010 -0.15% and S&P 100 Index (OEX.X) 509.65 -0.17%?

One thing that has changed a bit the past couple of sessions seems to be the market's perception, or thought on what the Fed is going to do with interest rates.

This has suddenly brought in some selling in the Treasury bond market, which has certainly had a monumental run higher in price, and had been driving YIELDS to multi-decade lows!

We've noted that the "relationship" between higher stock prices along with higher YIELDS began to change noticeably in May. In May, stocks continued to show gains, but Treasury YIELDS fell and buying continued.

While hindsight is always 20/20, the recent two-session weakness in banks, and selling in Treasuries may be related as to the perception or uncertainty among market participants on just what the Fed is going to do.

I'm beginning to think that Treasuries rallied so strong not only by traders buying Treasuries, but also the U.S. Treasury buying back Treasuries.

Why would the Treasury buy back its debt? By doing so, it pumps liquidity into a market. Right? If I am the Treasury and I buy your 5-year, 10-year or 30-year Treasury bond from you, you've now got cash right? If you're a corporation that has been holding some Treasury bonds, with excess capital generated from the late 1990's, you've probably got better things to do with $30 or $40 million dollars now, if the sudden interest dividend in your 10-year notes has been driven down to 3.4%.

I'm beginning to think with some degree of certainty, that the "reason" YIELDS had been headed lower, while stocks continued higher, was that Treasury buying may have been done to a greater degree as a "liquidity pumping" instrument, which may have actually helped improve the balance sheets and even income statements of corporation that could have sold Treasury holdings across multiple maturities.

Recent economic data showed that the risk of "deflation" might not necessarily be present, and the bond market sees selling based on the thought that maybe, just maybe, the Fed isn't as pressed to cut 50 basis points.

Has Mr. Greenspan or the U.S. Treasury pulled a fast one on us and actually been buying Treasuries in order to "artificially" (for lack of a better term) get liquidity into the markets in a more direct manner than any 25 or 50 basis point rate cut could?

Think of this. If the U.S. Treasury has been buying back some of its debt (bonds) its not to try and "profit" from this action, but to almost give a DIRECT INJECTION into the arm of the economy by pumping LIQUIDity into it. I'm thinking of this in terms of you or I (the economy) suffering from dehydration (economy struggling) and instead of swallowing water (rate cuts from Fed), we have been directly hooked up to an IV (intravenous) device (U.S. Treasury buying back its debt) and pumped full of fluid in a more direct manner.

Aha! You say. But all that does is INCREASE the deficit of the U.S. if its spending money to buy back bonds when its already cutting taxes, funding wars, and has been getting less tax revenue due to the slower economy! If this is the case you fool (Jeff Bailey) then its currency should decline because "its not worth the paper it is printed on!"

Suddenly, this begins making sense doesn't it? Have I been so blind to understand why the U.S. Dollar has been declining (printing money to buy back bonds) that has had Treasury YIELDS falling (can lower mortgage rates, provide liquidity to economy, a lot of things).

Hold on, I'm getting further revelations!

I'm so proud of some subscribers that have e-mailed me the past couple of days with the question/observation of...

"Jeff, what the heck is going on? Treasury YIELDS fall, stocks continue to gain, but last couple of days decent economic news on deflation, Treasuries see selling (yield rises) and stocks trade sideways!"

Here is a comparison of the U.S. Dollar Index (dx00y) and the 10- year YIELD ($TNX.X), which is considered the "benchmark" bond for Treasuries. The ONLY explanation I can come up with for why YIELDS have fallen (BUYING in Treasury) and stocks extending gains since April/May is that the U.S. Treasury has been printing money (creates excess dollars or supply of dollars) and created further dollar weakness. Sure, the war with Iraq didn't help the dollar, but I would argue that the U.S. economy is STRONGER than European economies as U.S. at least has positive GDP trends.

10-year Treasury YIELD / U.S. Dollar - Weekly Intervals

Let's first focus on the 10-year YIELD (upper chart). I've made to "benchmark" horizontal trends based on the relative lows of the 10-year YIELD, and then benchmarked those two levels on the U.S. Dollar Index (dx00y) chart.

Now, I've also shown "inflection" points of the S&P 500 Index (SPX.X), with SPX and a number. This shows how "things suddenly changed" in April and May, when in the past a lower bond YIELD found lower SPX, but when the 10-year YIELD continued to fall, stocks didn't and now have SPX at 1,000.

While I (Jeff Bailey) can not say for certain that the U.S Treasury has been an aggressive buyer of bonds, this analysis could be supported by the weaker dollar, where the buying of Treasuries actually has the bond market doing some of the Feds work as it relates to pumping liquidity into the U.S. economy.

The recent couple of days selling in Treasuries is most likely heavily influenced by bond TRADERS selling some of their bonds (taking profits) as recent economic data reduced some near-term fears of DEFLATION.

Now... Has the bond market done the bulk of the Fed work ahead of next weeks FOMC meeting and perhaps we've already gotten a flood of liquidity into the economy, but ONLY if it has been the U.S. Treasury doing the bulk of buying in Treasuries to provide the liquidity to the economy in a "round about way."

With the recent 2-day selling in Treasuries, spurred perhaps by the May CPI data, this creates a slightly higher YIELD.

I then pose the question to myself (and to you), what SECTORS of the economy are tied to interest rates (the Fed sets interest rates)? Financials is my answer. What sector of the economy is tied to Treasury YIELDS (the bond market and traders set these YIELDS as they buy/sell the bonds)? Home Builders and Financials!

Quick check.... today's trade saw the Dow Jones Home Construction Index (DJUSHB) 467.81 -1.81% and Housing Index (HGX.X) 292.60 -1.36% trade lower. The S&P Banks Index (BIX.X) 311.76 -0.3%, KBW Bank Index (BKX.X) 888.09 -0.83%, Broker/Dealer Index (XBD.X) 545.66 -1.97% and S&P Insurance Index (IUX.X) 274.92 -0.68%.

Now, one or even two days DOES NOT make a trend, but the past several weeks decline in bond YIELD and rising stock prices found stocks higher, and in the past couple of days, you and I have picked up on some rising Treasury YIELDS, but the financials are acting a little fickle (just two days) aren't they?

Is the housing sector in trouble? I heard "housing bubble" a couple of months ago.

Dow Jones Home Construction Index (DJUSHB) - Weekly Interval

While the DJUSHB is comprised of more than just homebuilders, we can really make a tie between its performance and Treasury YIELDS. I think the recent 40% gain in the past 10-weeks has had some bullish impact on the SPX/OEX too.

This sector, along with Treasury YIELDS should be monitored closely in the coming sessions, especially with the FOMC meeting next week. This sector may also be volatile as it relates to this week's option expiration. The great "market gods" can only know what types of hedge strategies have had to be placed on this sector or stocks within it, especially those that were short many stocks a couple of months ago that were CERTAIN a housing bubble was at hand.

This could be a sector that needs to be monitored closely in coming weeks. Not only as it relates to price impact on the SPX/OEX, but also MARKET PSYCHOLOGY.

Let's quickly discuss why I "hate" option expiration week and Triple Witching.

How can option expiration some into play and impact trading? Imagine this were a stock, you bought 1,000,000 shares on the breakout at 350. On the way up, you sold option contracts on 1/2 the position at 450 as you were willing to sell at 450 plus the premiums received. Are you buying back a loss (in the call options you sold) or are you ready to deliver 500,000 shares in the next couple of days? Now this is a "downside" type of scenario for unraveling.

Turn the table and pretend you were BEARISH and SOLD NAKED 20,000 contracts at 450 strike. If you would have put on such a trade, guess what you are OBLIGATED to deliver by expiration? You got it... 2,000,000 shares in the next day or two! This is the BULLISH thought to option expiration.

How do you or I hope to control any type of risk in a trade we currently have open? Pick a level to assess risk to is the ONLY way I know how. Can I put on a new trade right now with any great deal of confidence? I (Jeff Bailey) can't.

Now... tonight I've take a lot of time to try and explain what could be an important past development to understand, but more importantly, what could CONTINUE to be an important development yet to unfold and something I think we NEED to monitor!!!!!

A "worse case" type of scenario that I would be alert to is this. Dollar weakening and HIGHER Treasury YIELD.

Why? It would have to be my analysis that the only reason stocks have been finding higher price action is that liquidity to the markets has been created by the U.S Treasury buying Bonds, and pumping liquidity into the economy without even having to cut interest rates.

If the dollar were to continue below the recent lows, but Treasury start to find SELLING and YIELD move higher, then home builders and financials could be at risk.

Why financials? Insurance company's will take the premiums received from you and I do buy DEBT instruments like bonds (Treasury, high grade corporate, junk). I don't remember what update, but I mentioned months ago a comment I heard from a bond trader regarding "insurance companies buying all type of high grade corporate and junk bonds to get the then higher YIELDS." In recent months, that has been a GREAT trade and they've seen nice capital appreciation. But any type of financial that is tied to the bond market trade and YIELD could become vulnerable on any type of "quick and sudden" reversal in bond YIELDS.

The homebuilders are perhaps the most simplistic or easiest to have presented tonight BECAUSE mortgage rates are established from the TREASURY BOND MARKET.

Here's a quick look at the Pivot Analysis Matrix.

Pivot Analysis Matrix

Here's the "one trade" that I see potential for tomorrow, that really sticks out at me as it relates to the pivot analysis matrix.

The NASDAQ-100 Index (NDX.X) 1,247.90 +0.66% and QQQ $30.92 +0.52% were down early today and did violate their WEEKLY R1s. Still, the OEX/SPX managed to hold their WEEKLY R1s and when the rebound from today's lows took hold, it was the NDX/QQQ that traded the strongest.

What I see tomorrow is how we've got correlative resistance early at DAILY R1/WEEKLY R2 of QQQ $31.28-$31.30. If the NDX/QQQ can clear that level, then a bull has a nice target to shoot at in the correlative MONTHLY R2 and DAILY R2. Before ANY bull gets ready to "load the boat" for a bullish trade, make special note of the starting to deteriorate NASDAQ-100 Bullish %!

This type of action/trade to the upside could also be a bullish trigger for the other major indexes. On a bullish trade above $31.30 then I think you have to at least assess intra-day downside risk to the DAILY R1/WEEKLY R1 using correlative support (which would be tentative considering this morning's trade below) the DAILY S1/WEEKLY R1 of the NDX.

In essence, the NDX/QQQ become somewhat of a "key driver" for tomorrow.

SPX/OEX traders might also be keying off the BIX.X early in the session. Note today's close in the BIX.X is just above correlative support. For bullishness, I would look for the BIX.X to bid early. If it doesn't, then I'd use today's trade as an example that the SPX/OEX might be "dead money" near-term for a bull as the BIX.X may then fall to test DAILY S2/MONTHLY R1 correlation.

This might tie in with OEX DAILY S2/WEEKLY R1 correlation.

Again... I just don't know what to "expect" or really how to trade a Triple Witching expiration, without trading levels.

One thing that makes me a little jittery to try and profile a trade now for anything more that short-term, is that we've seen a HUGE run for the indexes, and I KNOW that there are some VERY sideways hedges, that could come off, and create substantial volatility.

I would rather at this point, leave it to you the trader to have yourself protected with some stops to control things based on YOUR risk/reward profile.

Let's quickly review the bullish %, because we're starting to see some further internal weakening in the NASDAQ-100 Bullish % ($BPNDX), which saw a net loss of 2 stock to point and figure sell signals today and has the bullish % slipping further to 85%. While this is now a net loss of 6 stocks from the bull cycle high of 91%, we don't chart a reversal on the bullish % chart until 84%. I know for a fact that Human Genome (NASDAQ:HGSI) $13.43 -7.5% was one of the stocks in the NASDAQ-100 to generate a point and figure sell signal, as it did it at $14.00 and had me stopping out of a prior bullish trade at $13.95 on this sell signal.

The S&P 100 Bullish % ($BPOEX) saw a net loss of 1 stock to a point and figure sell signal. This is minor slippage from yesterday's bullish cycle high reading of 81%.

The broader S&P 500 Bullish % ($BPSPX) saw a net loss of 2 stocks to point and figure sell signals. This is a decline of just 0.4%, but has the bullish % slipping back to 81.64% after Monday's bull cycle high reading of 82.83%.

The very narrow Dow Industrials Bullish % ($BPINDU) was unchanged and still stands at its bullish cycle high reading of 83.33%.

If anything, we're seeing some of the "larger cap" NASDAQ-100 stocks starting to see some risk removed as the bullish % begins to pull back from VERY high levels.

While Human Genome (HGSI) is a biotech, and by nature a little more volatile type of stocks, bulls need to be alert to such a rather "sharp" type of decline and understand that the MARKET can be rather unsympathetic when it decides to remove risk.

I found now news to explain today's decline in HGSI.

I'm going to borrow a line from Jim Brown tonight. Enter passively, but exit aggressively!

Jeff Bailey

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