Option Investor
Newsletter

Daily Newsletter, Tuesday, 8/10/2010

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

Fed Buys Treasuries

by Jim Brown

Click here to email Jim Brown

The FOMC decision today kept rates at the same level but they announced a revised form of monetary stimulus.

Market Stats Table

The market held its breath until the Fed spoke and then the volatility appeared. This is not unusual for a FOMC announcement although this meeting was probably a little more important than some because of the deteriorating economic conditions. The Fed kept the "extended period" language and most analysts believe it will not change until the second quarter of 2011.

The Fed also announced it was going to keep its level of securities holdings constant. This is a revised form of increased stimulus. The Fed has $2.05 trillion dollars of securities including mortgage backed securities they bought to support the mortgage market during the recession. Those mortgage securities were scheduled to expire at the rate of about $200 billion a year. The Fed said it would take the funds from the expiring mortgages and reinvest the money in "longer-term" Treasury securities. According to Bill Gross this would be 5-7 year treasuries rather than 30-year bonds. In a later statement by the NY Fed they said the buying would be in 2-10 year securities as well as TIPS and other maturities. They are going to spread that $2 trillion around to keep from owning all the securities of a specific type.

Since the mortgage backed securities had maturities of 2-5 years this represents a slight increase in term. By not specifying exactly which securities they were going to buy they got the benefit of lower yields all along the curve. Investors can't speculate on only one term in hopes of getting in ahead of the Fed so all treasury yields declined with the exception of the 30-year. The yield on the ten-year treasury fell to 2.74% on the news. Purchases of securities will begin on August 17th.

Some analysts had expected the Fed to announce a new quantitive-easing program. This constant level commitment is not really a new program but a conversion of the old expiring program with different securities.

The Fed did lower its projections for economic growth by saying new information "indicates that the pace of recovery in output and employment has slowed in recent months." This is more pessimistic than the "recovery is proceeding" comments after the prior meeting.

The FOMC also downgraded the forecast by saying "the pace of economic recovery is likely to be more modest in the near term than had been anticipated." This compares to the prior statement of "the pace of the economic recovery is likely to be moderate for a time." They kept the "inflation is likely to remain subdued for some time" sentence because FOMC members are becoming increasingly concerned about the possibility of deflation as the higher risk.

The decision was not unanimous. Kansas City Fed President Hoenig voted against the policy statement as he has done in the recent past. He believes that keeping the "extended period" language creates a market mindset that supports the deflationary conversation and limits the Fed's ability to adjust policy when needed. As long as that language is in the statement most analysts believe it would take a minimum of three to five meetings to change to a rate hike bias without shocking the market. The Fed moves in baby steps to give investors time to make changes in their bond portfolios in advance of the actual Fed change.

Hoenig also disagreed with the plan to buy treasuries. He did not believe that keeping the Fed balance sheet at its current size was necessary at this stage of the recovery.

The market was mixed on the statement with quite a few analysts negative on the Fed buying treasuries. That effectively monetizes the U.S. debt and will keep the interest rate on that debt at abnormally low levels. This type of action has been criticized every time it has happened in the past. The dollar plunged on the announcement with the dollar index falling about 50-cents. The world markets take a dim view of the U.S. monetizing its debt. The dollar index had been up sharply early in the day on the weakness in Chinese imports. Gold rallied $12 to $1208 on the announcement.

Dollar Index

In other reports today we saw that Wholesale Trade rose only +0.1% in June compared to estimates of +0.4% and the May growth at +0.5%. Sales declined by -0.7% and the second monthly decline. The combination of the wholesale trade and factory orders reports showed that stockbuilding contributed only +0.5 of a percentage point to GDP growth in Q2. This is significantly less than the +1.1% predicted by the Fed. This means the Q2 GDP could decline from +2.4% to a weak -1.7% in the next revision.

The Productivity and Costs report for Q2 showed that productivity declined by a whopping -0.9% compared to estimates for a +0.9% increase. By comparison productivity rose by +2.8% in the first quarter. The decline puts productivity back at the levels we saw during the recession in 2008.

Productivity Chart (Moody's)

In stock news the markets opened lower after disappointing news from China. Chinese import growth slowed to +22.7% in July from a very strong +53% in June. This is still strong growth but it shows the slowdown in China is progressing. China's GDP for Q2 fell to +10.3% from +11.9%. The headline number on the slowing imports is not alarming but some internal components declined significantly. The items that really declined were the ones that go into making the big products.

China Import Decline Table

The semiconductor sector and the PC makers suffered from multiple downgrades and weighed on the Nasdaq. JP Morgan warned that orders for PCs are "falling off a cliff." Barclays Capital told clients that third quarter PC sales "have continued to remain subdued and Intel's seasonal sales guidance may prove bold." Robert W Baird & Co said computer sales are being hurt by high unemployment, austerity measures in Europe and China and the end of stimulus spending in the USA. Baird downgraded Intel to a neutral.

JP Morgan said channel checks showed PC makers were slashing their orders for new components. HPQ and Acer have cut orders to suppliers of laptop parts. Acer and Lenovo have cut orders for chips. This prompted JPM to lower the estimates for Intel's production and profits.

Wedbush analyst Patrick Wang sent out a note saying a series of channel checks in Asia left him "incrementally more negative on the PC supply chain" and "visibility is now hazier than before, back to school builds have under whelmed and inventories are modestly higher."

JPM said Apple was partly to blame because the iPad was cutting into laptop sales. This is a positive for Apple's earnings for Q3. By the end of the quarter there will be several other tablet computers in the market so laptops are going to continue to be under pressure. Since tablet computers are increasing so sharply you would think the chip sector would be bullish but evidently not for the PC makers and Intel. Shares of Intel fell -4% on the downgrades and pressured the Dow and Nasdaq indexes.

Intel Chart

Semiconductor Index Chart

Disney (DIS) posted earnings of 67-cents that beat analyst estimates of 58-cents. Revenue rose +16% to $10 billion. Disney shares gained slightly after the close.

Novell (NOVL) slashed its third quarter revenue outlook after the close on Monday and shares plunged on Tuesday. Novell now expects revenue of $198 million compared to prior forecast of $207 million. Analysts were expecting $207.1 million. Novell said the drop in revenue was due to a negative effect from customer uncertainty over the direction of the economy.

Fossil (FOSL) reported blowout earnings of 80-cents compared to estimates of 34-cents. Growing consumer appetite for the company's cheaper private labels were credited with the gains. Fossil sells its cheaper watches at stores like Wal-Mart, Target and K-Mart. Shipments jumped +40% in the quarter and Fossil is going to capitalize on this trend by introducing even lower price points and a broader assortment of styles. Shares rose +9% on the news.

Scott's Miracle-Gro (SMG) reported earnings that rose +19% to $2.59 per share. Analysts were expecting $2.45 per share. The CEO said earnings would have been higher except that momentum slowed at the beginning of May due to unfavorable weather. They reaffirmed guidance inline with estimates and said the board authorized a $500 million stock buyback. SMG started the day with about a $2.50 gain but gave back some of its gains at the close.

Aflac (AFL) said it was raising its dividend from 28-cents to 30-cents and resuming its stock buyback program that was suspended in 2008 to conserve cash. Aflac said it had 32.4 million shares left to buy.

The House was called back into session to pass another stimulus bill for $26 billion. This stimulus program was called a jobs bill by the democrats and a bailout by republicans. The bill supplies grants to states to keep union jobs that were expiring because of the end of the original stimulus program. The bill was passed by the House after lunch and signed by the president immediately thereafter so lawmakers could quickly return home to prospect for more votes armed with another public relations bonus bill in their pockets.

It was originally a $10 billion bill but they could not get enough votes to pass it in its original form. They had to add $16 billion of bailouts in the form of medicare payments to the states to get enough votes to pass it. That means it is only a $10 billion jobs bill. The bill will be paid for by cutting food stamps to 40 million people by $12 billion and raising taxes on U.S. multinational companies by $10 billion. The House also passed S.3721 a $600 million bill to boost security on the Mexican border but the modified bill has to go back to the Senate for another vote.

The markets celebrated the Fed announcement with a return from a triple digit loss on the Dow but was unable to hold the gains. The Dow recovered from a -150 point opening plunge to trade positive shortly after the announcement but then ended with a -54 point loss. The markets were dormant on Monday with the lowest volume day in a year at only 5.6 billion shares. Today was not much better at 7.3 billion and the internals were significantly worse. The new 52-week lows were the highest since July 20th and the advance decline ratio was 3:1 in favor of decliners.

I read and heard several analysts claiming the Fed's action was a reason to buy stocks but I don't think the market believed them. The Fed said the recovery was slowing and the length of time it would take to recover was expanding because of the slower growth. That makes stocks a very long-term proposition rather than prospects of a quick gain before year end. While I don't disagree that stocks will probably do well over the next couple years I question if investors are motivated to jump in today in a deteriorating economic environment. Investors want to know that the economy is growing not shrinking. Granted +1.4% to +1.7% GDP growth is still growth but snails crawl faster than that.

Investors are long term and they may want to own stocks today for 2012 returns. Traders don't want to own stocks in a declining environment and trading makes the markets move. If everyone was an investor and sat on their portfolio the market would flat line for lack of activity.

So we have to ask ourselves "why would traders want to go long today?" Earnings are over except for HPQ (8/19), Dell (8/19) and CSCO on Wednesday after the close. There are still hundreds of small companies to report but if you were bored reading about NOVL, SMG, AFL and FOSL in the paragraphs above then you are going to hate the next couple of weeks of earnings because there will be plenty more of those smaller names.

The major earnings are over after Cisco reports tomorrow and the FOMC meeting is now behind us. We are in the worst two months of the trading year in Aug/Sep so why should traders go long now?

Despite the lack of a reason the S&P is still clinging to resistance just under 1130. This could be considered a near miracle since it has held the July gains and closed over 1120 for seven days now. Resistance is solid but support has been bought twice now to short-circuit what could have been a decent start to a decline. The bulls are still active even without a valid reason to buy.

You may remember a week ago I listed the reasons why I was bullish longer term and those reasons still exist. I just believe we could get an opportunity to buy stocks lower before August is over.

Support on the S&P is 1110 and resistance is still 1127. The converging resistance at that level is very strong as evidenced by the dead stop there over the last seven days. Support may be rising slightly with today's lows more like 1113 than 1110.

S&P-500 Chart

The Dow chart is a carbon copy of the S&P with 10,700 resistance and 10,500 support. However, the Dow is above the 100-day average where the S&P can't break through that barrier. Despite the Intel downgrades Travelers and MMM were bigger losers than Intel out of the Dow 30.

I still do not want to use the Dow as a trading indicator but a move over 10,700 would probably trigger short covering and a move higher.

Dow Chart

The Nasdaq gave up -28 points on the downgrade to the semiconductor stocks. Support remained firm at 2260 but tech sentiment is worsening. It is possible tech bulls have not yet thrown in the towel because they are waiting on the Cisco earnings on Wednesday. Hoping for one last earnings pop could be a dangerous game. If Cisco gives anything but strong guidance we could have a strong implosion in techs on Thursday. Remember, Cisco is not selling PCs. They are selling high dollar routers and switches to major companies. Quite a few of those major companies made their Q2 earnings on cost cutting not on higher capex spending. I am not saying Cisco is going to disappoint but even good earnings were sold over the last several weeks.

For the Nasdaq I would be concerned on a decline under 2260. Next support is 2225 but I think once the trend changes we could fall further than initial support. These two months are not kind to tech stocks.

Nasdaq Chart

The Russell lost -2% on Tuesday and nearly twice the Nasdaq loss and four times the Dow loss. The Russell has a clear pattern of lower highs and is honoring the downtrend resistance from April. The 200-day support at 642 was tested and the rebound was minimal. It was enough to be a successful test but not enough to encourage the bulls to come back into the market. If the Russell breaks below the 200-day I believe the other indexes will also fail.

If the Russell declines below 640 it would confirm my short-term bearish bias.

Russell Chart

In summary, why buy? In the short term once Cisco's earnings are over there are no material events in our near future to stimulate the bulls into buying the market. The HPQ and Dell earnings next week are an afterthought and not really market moving events. The critical economic reports are behind us and the Fed downgraded their recovery forecast. Markets can go up when they should go down as bulls climb the proverbial wall of worry. That wall is increasing in height and complexity and sentiment is worsening. A move over S&P 1130 would be confirmation that the bulls have their climbing shoes on and would trigger some serious short covering. A Russell move under 640 would confirm the short-term bearish bias.

Jim Brown


New Option Plays

Short Candidate

by Scott Hawes

Click here to email Scott Hawes


NEW DIRECTIONAL PUT PLAYS

Leggett & Platt - LEG - close 20.88 change -0.55 stop 21.75

Company Description:
Leggett & Platt, Incorporated is an international manufacturer, which conceives designs and produces a range of engineered components and products found in many homes, offices, retail stores and automobiles. The Company’s operations are organized into 19 business units, which are divided into 10 groups under four segments: Residential Furnishings; Commercial Fixturing & Components; Industrial Materials; and Specialized Products.

Target(s): 19.85, 19.35, 18.70
Key Support/Resistance Areas: 21.50, 20.50, 19.80, 19.00, 18.50
Time Frame: 1 to 2 weeks

Comments:
We are back with a short play in LEG. LEG is in the furniture & fixtures industry and purchases of these types of items are not on the minds of consumers. The stock continues to make lower highs on a descending trend line that began on 4/30 and is now on the verge of breaking an upward trend line that began 7/6. On its daily chart LEG closed below all of its moving averages today and if the broader market gets moving to the downside LEG should be one of the first to go. I suggest we enter short positions if LEG trades to $21.20 (below today's highs and the 50-day SMA) or to $20.70 (below today's low), whichever occurs first. We have realistic targets that are easily achievable and will produce a good winning trade if they are reached.

Suggested Position: Buy September $20.00 PUT, current ask $0.60

Annotated chart:

Entry on August xx
Earnings: 10/21/10 (unconfirmed)
Average Daily Volume: 1.45 million
Listed on August 10, 2010


In Play Updates and Reviews

Markets Are Confused After FOMC Announcement

by Scott Hawes

Click here to email Scott Hawes
Current Portfolio:


CALL Play Updates

SPDR KBW Bank ETF - KBE - close 24.05 change -0.14 stop 23.25

Target(s): 24.85, 25.30, 26.00
Key Support/Resistance Areas: 26.00, 25.50, 24.85, 23.75, 23.35
Current Gain/Loss: +5.5%
Time Frame: 1 to 2 weeks
New Positions:

Comments:
8/10: We are long KBE calls at the open at 90 cents and are looking for the bank ETF to bounce up towards its 100-day SMA which is above our first target of $25.30. A move up to this area should produce a +50% gain on this position. Readers may also want to consider an added target of $24.85 as an area to tighten stops or take profits. This will also produce a nice gain and is a resistance from late July/early August to consider.

8/9: KBE has strong support in the $23.50 to $24.00 area (see rectangle on the below chart) and has printed two bottoming tail candlesticks the past two trading sessions. The ETF has formed a bullish inverse head and shoulders pattern and has maintained an upward trend line off of its July 1 lows. KBE is also being supported by its 20-day, 50-day, and 200-day SMA's which could act as a springboard for a move higher. Tomorrow's FOMC announcement is a wildcard so traders may want to see the market's reaction (or close) prior to entering positions. We'll use a tight stop at $23.25 which is below the daily upward trend line.

Current Position: Long September $24.00 CALL, entry was at $0.90

Entry on August 10. 2010
Earnings Date N/A (unconfirmed)
Average Daily Volume: 3.5 million
Listed on August 9, 2010


Volatility Index - VIX - close: 22.37 change: +0.23 stop: 19.60 *NEW*

Target(s): 25.95, 27.30, 28.90, 31.50, 35.00
Key Support/Resistance Areas: 20.00, 22.00, 24.00, 26.00, 28.00
Current Gain/Loss: N/A
Time Frame: 2 to 3 weeks
New Positions: Unopened

Comments:
8/10: VIX came within 1 penny of triggering our entry to buy calls. And it's a good thing we didn't get triggered because just after the FOMC announcement stocks took off and the VIX plummeted, so we caught a break on this one. Last night I mentioned aggressive traders may consider entering at current levels. But I just wasn't ready to officially make any changes to the play due to the FOMC announcement today. However, I'm suggesting we take advantage of any further weakness in the VIX which should happen if stocks rally from here. We may get a little further upside but the fact is we are in overbought conditions and the market is complacent, not to mention the seasonality. And it is not uncommon for stocks to reverse course from the initial FOMC reaction. In fact, on June 23rd the S&P 500 bounced hard intraday just like today, but then proceeded to sell off -80 points over the ensuing week. I realize the circumstances are completely different now but look at the daily S&P 500 chart. Currently we are just above the same levels as June 23rd and are also coming off of a strong rally. I suggest we enter positions now and look for a bounce up to its 50-day SMA which is above our first target of $25.95. We'll use a stop of $19.60 and if the market rolls over I suggest traders trail their stops. I've adjusted the targets.

8/7: If you are reading the market commentary then you know we don't trust this market rally and expect stocks to turn weak again as we head into fall. When stocks do roll over it should produce a rally in the VIX. I am suggesting a trigger to buy calls on the VIX if the index hits $24.25. We'll use a stop loss at $21.45. If triggered our first target to take profits is at $29.00. Our second targets is $32.00 and our third and final target is $35.00.

NOTE: September VIX options expire on Wednesday, Sept. 15th, not Friday

Suggested Position: Buy September $30 CALL, current ask $2.25

Entry on August XX
Earnings Date N/A
Average Daily Volume N/A
Listed on August 7, 2010


PUT Play Updates

SPDR DJIA ETF - DIA - close 106.66 change -0.46 stop 108.75

Target(s): 106.25 (hit), 105.40, 104.75, 103.65
Key Support/Resistance Areas: 108.00, 107.00, 105.90, 104.75, 104.20, 103.50
Current Gain/Loss: -15%
Time Frame: 1 week
New Positions: Yes

Comments:
8/10: DIA keeps getting close to hitting our target but the market keeps getting saved. Today in early trading this position could have been closed for a +10% gain but stocks rallied. I suspect we may have a spike in the markets over the next day or two but I do believe we will get a meaningful correction that could happen at anytime within the next week, and it could happen fast. DIA is forming a bearish rising wedge pattern and if it lets go we should see a $2 or $3 drop relatively quick. This is what we are positioned for and should the drop happen I suggest readers begin to tighten stops as our targets approach to protect capital and against a reversal.

8/9: On Friday DIA came within 6 cents of hitting our 2nd target so I have raised it by 15 cents. Friday's late day rally looked like classic short covering to me but, nonetheless, it is a support level to be aware of for potential exits or an area to tighten stops to protect capital. If DIA breaks Friday's low it should continue lower to our more aggressive targets. Now we await tomorrow's reaction to the FOMC announcement. This most likely means a volatile afternoon session and may present some opportunities to exit positions. It could happen fast just like Friday but this time it might keep going.

Current Position: Long September $106.00 PUTS, entry was at $2.70

Entry on August 3, 2010
Earnings: N/A (unconfirmed)
Average Daily Volume: 14 million
Listed on August 2, 2010


Occidental Petrol. - OXY - close: 77.81 change: +0.86 stop: 76.25

Target(s): 70.50, 66.00
Key Support/Resistance Areas: 75-74.00, 70.00, 65.00
Current Gain/Loss: N/A
Time Frame: Three or Four Weeks
New Positions: Yes, trigger at $73.90

Comments:
8/10: OXY doesn't seem ready to break down just yet as the stock gained +1.12% today on a weak tape. The stock is approaching all of its major SMA's from below and a down trend line near the $80 level. This sets up a good short entry as opposed to waiting for a break down. I'm assessing this option and may change the trigger in the coming days.

8/7: Shares of OXY have been underperforming their peers in the oil sector for weeks. The sell-off appears to be picking up steam and this time I think it will breakdown under key support near $75.00-74.00. Most of the lows over the past several months have been near $74.25. I am suggesting a trigger to buy puts at $73.90. If triggered I'm suggesting a stop loss at $76.25. Our first target is $70.50. Our second target is $66.00.

Suggested Position: 2010 Sept. $70.00 puts (OXY1018U70) current ask $1.09

Entry on August XX
Earnings Date 10/21/10 (unconfirmed)
Average Daily Volume = 4.4 million
Listed on August 7th, 2010


Procter & Gamble - PG - close: 60.78 change: +0.40 stop: varies

Target(s): 59.30, 58.05, 57.25
Key Support/Resistance Areas: 59.00, 61.00
Current Gain/Loss: -5%
Time Frame: 2 to 3 weeks
New Positions: Yes

Comments:
8/10: PG triggered our higher target to enter positions at $60.69. We are long $57.50 PUTS at 36 cents. This is a cheap out of the money option that shouldn't move too much with underlying price of PG. But if we get PG to retest its recent lows, which are below our first target of $59.00, we should easily make 25 cents on the position. This would represent a +69% gain. As such, I've removed the $55.00 target and added three closer targets that are very easily achievable.

8/7: PG reported earnings last week. The company missed estimates and guided lower. Shares gapped down but the selling stalled near support around $59.00. You might think that a consumer products company like PG would be see as a strong, safe-haven play. Yet the stock has been building a topping pattern over the last several months. Now shares look ready to begin a new leg lower. I am suggesting two different triggers to buy puts. PG might fill the gap created this past week. If the stock does see a bounce I am suggesting we buy puts at $61.00 with a stop loss at $63.26. On the other hand if PG rolls over from here we want to buy puts if PG hits $58.80 and use a stop loss at $61.05. Our bearish target is $54.00 and our time frame is approximately four weeks.

Current Position: Long September $57.50 PUT, entry was at $0.36

Entry on August 10, 2010
Earnings Date 10/28/10 (unconfirmed)
Average Daily Volume 2.5 million
Listed on August 7th, 2010


CLOSED BULLISH PLAYS

ProShares UltraShort 20 YR Treasury - TBT - close 35.87 change -0.14 stop 35.55

Target(s): 36.90 (hit), 37.50 (hit), 38.00, 39.25, 40.50
Key Support/Resistance Areas: 42.00, 41,00, 39.70, 38.25, 37.55, 34.65
Final Gain/Loss: -43% < br> Time Frame: Several Weeks
New Positions: Closed

Comments:
8/10: We were stopped out of TBT right around the FOMC announcement this afternoon. There was a knee jerk reaction and TBT sold off in a 15 minute period before recovering all of the day's losses and closing near its highs. We had two opportunities to take profits on this trade which was obviously the right thing to do at the time. Today's selling may have hit several stops which could have caused a capitulation type event so if readers still have positions I would use a stop below today's low and see how far TBT can take you. I still like the play and think longer term holders could be handsomely rewarded.

8/9: We are hanging in here with TBT and any breakout in equities should get this ETF moving in our direction in earnest. I believe bond prices are close to or at a top and could experience a steep decline in the near term (bullish for TBT). Regardless of whether or not that happens I suggest being prepared to exit positions or tighten stops at the any of the above targets as they approach. All are still valid.

Closed Position: Long September $37.00 CALL at $0.70, entry was at $1.23

Annotated chart:

Entry on July 26, 2010
Earnings N/A (unconfirmed)
Average Daily Volume: 3.8 million
Listed on July 24, 2010