Option Investor
Newsletter

Daily Newsletter, Thursday, 8/2/2012

Table of Contents

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

Market Wrap

What the Central Banks Giveth They Taketh Away

by Keene Little

Click here to email Keene Little
Last week's declaration by the ECB's Mario Draghi that they're prepared do everything possible apparently meant at some future date instead of Now. The market was not happy with the delay.

I apologize for the delay in tonight's report. I'm currently dependent on cell service for my internet connection and T-Mobile decided this afternoon was the right time for some preventive maintenance work, which obviously turned into a bigger problem and of course they had provided no warning that they were going to take the system down. All cell service has been lost in my area (I'm isolated at a family vacation spot) and multiple phone calls on someone else's iPhone (but with no wi-fi hotspot to use) with T-Mobile has resulted in nothing.

I lost service around 2:00 PM and as of 11:00 PM they still don't have an estimate for me. As soon as I get connected I'm going to hit the send button with what I've got (it's already too late). To say that I'm a little frustrated and highly pissed at T-Mobile would be a gross understatement. Whatever you do, don't give your business to T-Mobile. The last thing they care about is customer service. I was even twice "accidentally" hung up on while on a call with customer/tech service and no effort was made to call me back either time. And it takes 10 minutes to even reach a live person (and they wonder why we're already angry before we even get a live person). Grrr...

OK, onto the market. During the overnight session equity futures had worked their way higher with the European market as traders anticipated that ECB's Mario Draghi would follow through on last week's verbal intervention. But at 8:30 EST we received his prepared remarks and there was little evidence that he was prepared to do NOW what he promised last week. Needless to say the traders were not happy and immediately hit the sell button. A spike high to ES (S&P e-mini futures) 1383 (+12.50) was followed in the next 10 minutes a drop to 1361.50 (-9) for a 21.50 point swing. That swing resulted in the market opening with a gap down, which was immediately followed by a rescue attempt but it didn't hold. This afternoon's price action leaves a question about whether or not the market has made a turn back down.

After the market ramped higher last week, on Draghi's promise that he would do everything possible to support the EU and the sovereign debt issues, he didn't deliver on that promise today. Following Bernanke's lack of enthusiasm yesterday in committing to more stimulus the market continued to hold up on expectations that Draghi would surely deliver on his promise. Oops, I guess verbal intervention is about all they're willing to commit to at the moment. Lots of talk, little action. If it's not becoming ever more obvious that these bone heads only know how to talk up a market instead of actually manage one, you're not paying attention.

I thought John Gray summed it up nicely in a note this morning:

"European Central Bank President Mario Draghi on Thursday said in his monthly news conference in Frankfurt that the central bank may undertake additional 'outright open market operations' and governments should stand ready to unveil rescue funds to buy government bonds, but stopped short of identifying specific new measures to tackle Europe's debt crisis.

"This is a case of letting your mouth overload your a**. Mario Draghi put his own reputation on the line last Thursday by declaring the institution (ECB) was ready to do "whatever it takes" within its mandate to preserve the euro, adding for good measure: "And believe me, it will be enough." The market knee-jerked higher in response. Now, it is time to put up, or shut up. We got our answer this morning.

"It was rumored that the ECB is planning to undertake coordinated action with the European Stability Mechanism (ESM), the euro-zone's permanent rescue fund, to buy Spanish and Italian government bonds. ESM would buy in the "primary" market and the ECB would buy in the "secondary" market. There is just one small problem however – Germany. Germany's participation in the ESM is anything but certain. Twelve lawsuits have been filed in Germany seeking to ban that country's participation in the ESM. A ruling on these suits is not scheduled to take place until September 12th. Germany's commitment to the euro is absolutely crucial to its survival.

"'Bond Vigilantes' will ultimately have the last word here. The goal of the above-described plan is to lower the borrowing costs on Spanish and Italian bonds which have reached unsustainable levels (over 7%). If private purchasers of these bonds are subordinated (junior) to those purchased by the ESM/ECB who is going to buy them, and at what price? You may recall that this is exactly what happened with Greek bonds, i.e., private bondholders were given a choice -- either accept a 70% write down, or take nothing at all.

"Ultimately, the safety and security of these bonds rests with the sovereign borrower. Personally, I'm not interested in lending money to a country that is officially in a recession, has a 24% unemployment rate, and shows no interest in taking measures to end its profligate ways."

So we can guess why Draghi is not committing -- he can't get Germany to go along with the plan. The big question is why Bernanke is hesitating. What's holding him back? As I've been discussing for a while now, I believe Bernanke is essentially out of bullets and at most has one more attempt to make a difference. He is reactive and not proactive, which means he's not going to waste further monetary easing until he sees the market panicking. He knows he's got one more shot at this before he (the Fed) loses all credibility.

With ALL previous attempts to monetize the debt, to boost liquidity to help the markets, along with the ZIRP (zero interest rate policy), the Fed has been a failure. Bernanke & Co. (and the ECB) are desperate now to hold onto any vestige of credibility, especially with a Congress now getting closer to authorizing an audit (thanks to the relentless pursuit of this by Ron Paul), and any more failures of another QE program would have the Fed doing some serious life support on themselves.

If Bernanke implemented another QE program and the market didn't respond or the rally was very brief or worse, it sold off, all the jawboning in the world is not going to help. It's likely that Bernanke knows more QE will not help the economy and instead only be the last nail into the consumer's coffin by jacking up food and energy prices. Surely even the Fed recognizes that the half-life of all their attempts have been getting shorter and shorter.

With the Fed and ECB failing to act now, it will be important what is said (or not said) at Jackson Hole later this month (where the whole QE program idea was launched). The difficulty is that it's too close to the elections and the Fed is desperately trying to avoid being painted with a political brush. The Fed needs to be viewed as a non-political entity if it hopes to survive. So from this perspective, the Fed has painted itself into another corner.

Once the market realizes their Emperor wears no clothes there will be significant problems holding up in face of a global slowdown. The financial markets are built on faith, just as the banking system is and as is the entire credit system. Our fiat currency is built on the faith in our government to back the value of the dollar. The financial credit system is based on faith that money owed will be money paid. The stock market has faith in the Bernanke put and that somehow the banks really do have control of their risks. What will happen when all this faith starts breaking down? I believe the Fed is most afraid of this since it's the most fragile and the hardest to combat. Fighting inflation and deflation, helping unemployment, keeping the economy growing -- it's all an illusion based on faith that the Fed actually controls things. They don't but as long as the majority have faith in them, and our fiat currency, the longer the game can continue. Bernanke is deathly afraid of the game ending.

And this is why Bernanke & Co. will wait for a panic before unleashing another, and likely final, round of QE. They'll need to see the market rally on expectations that it will work this time. Unleashing another round of QE now would be a complete waste of their remaining bullet (actually there will be one more bullet which they'll use to defend themselves by bailing out of all banking contracts to protect their own asse(t)s -- remember this is a private consortium of banks). After another failed QE program the game will be over for the Fed and with that there will be a loss of faith in the entire system and down she'll go. That could be this year or 5 years from now. Japan has been stretching out this process for over two decades (we're into our 2nd decade) but they've had a big advantage, which is now ending, with a high internal savings rate by the people. As soon as Japan is forced to go to the outside market to support their debt load their game will be over.

This all sounds very bad and scary and in many respects it will be. But keep in mind that the system we have now benefits very few and hurts the majority (think savers, especially retirees right now). The process of cleaning the bankers' drawers will be a correction that will pay huge dividends to the majority once the correction has finished. The bankers do Not want this correction process to continue, for obvious reasons. The political and financial heads have a vested interest in seeing this game continue as they accumulate as much wealth and power as possible.

Frankly I'm looking forward to the correction because I view it as very positive. I especially look forward to the other side when we'll have one of those generational investment opportunities. Keep in mind that the Great Depression birthed some of the greatest companies in the 20th century and a very long bull market (in spite of WWII and the wars that followed, not because of them -- wars are extremely wasteful of resources). I fully expect the same kind of growth opportunities out of the Greater Depression and it will take some careful observations to identify them, something I'm very much looking forward to (when I can stop complaining about Bernanke, wink).

When will it all end? If only we knew but I suspect we're looking forward to at least 2016 before bottoming, maybe longer if the political/financial games can continue much longer. The only thing I can do is study the chart patterns and make some educated guesses as to what it will look like as we move forward.

I'm flying blind tonight, not knowing how the final two hours of the day went so please bear with me with what I've got.

Last Friday I had updated my SPX "MPTS" chart to show the correlation between market turns (or not) and new and full moons. What's interesting is the fact that each high since June 4th has occurred on a new or full moon. As we were heading for August 1st, Wednesday, I thought the setup was very good for another high that would be coincident with the full moon. The high of the bounce was on Monday, July 30th and the market has been down since. Not a bad correlation. Where to next is now the bigger question.

S&P 500, SPX MPTS, Daily chart (as of July 27th)

Last week I had mentioned 1392 for SPX as a potential upside target for the rally since that was a projection based on wave relationships in the move up from June 4th. As the rally progressed into July 27th I had a new projection at 1389.01 to watch, using an A-B-C wave count instead of a jumbled mess of a double zigzag pattern. The a-wave is the leg up into the June 19th high, followed by the very choppy b-wave over to the July 24th low (common messy pattern for a b-wave) and then the c-wave up into the July 30th high. The corrective wave pattern is still not clear but the upside target zone became 1389-1392 and Tuesday's high was 1391.74. Gotta love them Fibs and wave relationships. That makes the decline from Tuesday potentially the start of next major decline (3rd wave of the move down from April.

S&P 500, SPX, Daily chart (as of 2:00 PM price)

Key Levels for SPX:
- bullish above 1392
- bearish below 1329

Since I'm flying blind here, not knowing how the final two hours of the day went, the chart below is one I had put together a little after 1:00 PM. If the bearish wave count (calling the move down from Monday as a series of 1st and 2nd waves) is correct we'll see the market stair-step lower into early next week and a downside target for now is near SPX 1340, where it would meet an uptrend line from June 25th (the bottom of a parallel up-channel containing price action since the June 19th high and 25th low). A bounce off that trend line next week, with a subsequent failure at or below the mid line of the channel, near 1370, would make for a very nice setup to get short for a good swing/position trade. Because we don't yet have a 5-wave move down from Monday, another rally leg can't be ruled out yet (dashed green line). So just keep it in mind when managing your trades.

S&P 500, SPX, 60-min chart (as of 2:00 PM)

As with SPX, a chart update that I had done near 1:30 PM for the RUT shows the very bearish wave count for the move down from July 5th. It had been weaker this week through Wednesday but then had a "less bad" day compared to the blue chips. It looked like the blue chips did a little catching up (down?) while the RUT held back some. The RUT was down -0.6% while the blue chips were double that and down about -1.2%. Early this afternoon the RUT was testing last week's low near 765, with a low of 765.20 (I'm not sure if that ended up being the low of the day). If it turns back up from 765, with the small bullish divergence shown on the chart, it will have us wondering if we'll get the start of another rally leg. I would argue for the bullish case if it gets back above 780-ish. We might see a little bounce/consolidation before heading lower and testing the bottom of its down-channel from July 5th high as well as its June 26th low, both near 758. Below 758 would strengthen the bearish position considerably.

Russell-2000, RUT, Daily chart (as of 2:00 PM)

Key Levels for RUT:
- bullish above 800
- bearish below 758

On Tuesday I was looking at a possible double top for the banking index, BKX, as shown on the 120-min chart below. As the higher highs since June 4th became weaker it formed a rolling top, which is a common topping pattern. In addition to the double top it was also a test of its broken uptrend line from June 4th. When it dropped back down into the close on Tuesday (following the failed back test) it was a very good pattern to short, using the day's high for your stop.

KBW Bank index, BIX, 120-min chart (July 30th)

I don't have an updated chart but there was one more quick stab back up to the broken uptrend line Wednesday morning and then a sharp decline through today. The decline on Wednesday and today's decline added to the look of a reversal for the banks but the rounding top pattern could mean a lot of whippy price action following the curve shown on the chart before dropping sharply and breaking the June 4th low.

Because of gold's choppy pattern I'm wondering if the sideways triangle pattern that I've been showing for weeks has morphed into a slightly larger one, a very common occurrence. Tuesday's high came very close to a projection at 1632.50 for two equal legs up from July 12th (with a high of 1631.60 on Tuesday). We might be looking for one more down-up sequence into the end of the month before gold is ready to sell off. The more immediate bearish risk is that the consolidation since May is finished and the next leg down has now started. A drop below 1550 would be a bearish heads up while it still takes a rally above the June 6th high at 1642.40 to indicate we'll get a larger bounce, potentially up to its downtrend line from September 2011, currently near 1670. A lot of traders/analysts I respect are looking for a good rally but I don't see it, especially now with today's decline, which dropped it below the July 18th high, leaving a confirmed 3-wave bounce correction (another in what could become a larger triangle pattern).

Gold continuous contract, GC, Daily chart

That's all I was able to pull together tonight without having the ability to retrieve and update my charts this afternoon. Hopefully it's enough to give a feel for what this market is doing. Unfortunately the price pattern is not yet clear. I'm feeling rather bearish about the market and want to get short and hold on. But we don't have an impulsive move to the downside yet and with each move since June 4th being a 3-wave move followed by a reversal that remains true right here -- we could see yet another reversal and start back up again. Why it would rally is beyond me, which is exactly why it might. At least remain aware of that possibility.

On the SPX 60-min chart I show a downside pattern that calls for the market to stair-step a little lower and if that plays out then we'll have an impulsive 5-wave down and we'll know to be looking to short the bounce correction following that move down. That might be a couple of days or toward the end of next week. Hopefully by next Wednesday this will become much clearer. Again, sorry not to have more to review with you tonight.

Good luck and I'll be back with you with a full complement of charts next Wednesday (if T-Mobile gets their $%^#%! act together).

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying


New Option Plays

Shopping More, Spending Less

by Jim Brown

Click here to email Jim Brown
Everybody wants to save money and with a recession looming that becomes even more critical.

Editor's Note:

I hate to go to the store and walk out with a couple of bags and a hole in my wallet. It seems like every major retailer is marking up prices to compensate for slowing sales.

In today's call recommendation we have a company that makes a business out of buying everything as cheap as possible and selling to customers as cheap as possible. No, it is not Wal-Mart. I am talking about Dollar Tree.

The company has been sold over the last month in a post split depression phase but I think that is about over. Typically when companies split their stock the new share of stock is considered a dividend and taxed accordingly. Funds and individuals can sell those new shares at a reduced tax rate. That selling immediately after a split causes a post split depression. With dividend tax hikes a real potential for 2013 we have seen a stronger than normal post split depression on DLTR. With shares resting on long term support we should see new buyers in the market.

James is on vacation this week.


NEW DIRECTIONAL CALL PLAYS

Dollar Tree - DLTR - close: 50.63 change: +.62

Stop Loss: 49.50
Target(s): 54.50
Time Frame: 3-4 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
Dollar Tree is a dollar store. In these times of economic stress and high unemployment consumers are always looking for a way to stretch their dollars. Shopping at a store like Dollar Tree is a great way to save with items priced 35% to 50% below normal retail in a regular store.

Dollar Tree has a profit margin of 7.39% overall compared to Wal-Mart at 3.68%, Target at 4.68% and Costco at 1.73%. The downside is that Dollar Tree does not have all products all the time. Consumers have learned to live with that limitation.

We saw consumer sentiment decline in July to the lows of the year and the risk of recession rose to the highs for the year. This makes the dollar stores even more attractive.

With the market in turmoil and no solid trend institutions will be looking for solid, under loved, companies for their investable cash. Dollar Tree has 45% institutional ownership with only a 2.74% float.

DLTR has limited exposure to Europe or to currency conversion issues currently impacting international companies. They recently split the stock 2:1 on June 26th and companies that split normally regain the prior price ($110) within 12 months. That rebound has not yet appeared.

The 100-day average has been strong support since early 2011. That average is $50.65 and the stock closed at $50.64 today.

The stock bounced at the open this morning thanks to the higher than expected retail sales for July. Resistance is $51. I am recommending we enter the position with a trade at $51.25.

Trigger: Enter only with A DLTR trade at $51.25

- Suggested Positions -

Position: Buy Sept $52.50 Call (DLTR1222I52.5), currently $1.60
DLTR Chart

Entry on UNOPENED xx at $ xx.xx
Average Daily Volume = 1.5 million
Listed on Aug 2, 2012


NEW DIRECTIONAL PUT PLAYS

No new bearish plays today


In Play Updates and Reviews

No Real Surprise

by Jim Brown

Click here to email Jim Brown
The ECB failed to impress and the markets reacted accordingly.

Editor's Note:

The head of the ECB, Mario Draghi, is no longer super. Instead of doing "whatever is necessary" he did nothing and the market sold off hard at the open in response.

Many individual stocks failed to decline significantly but those stocks related to commodities were crushed. Some energy stocks were sold hard as the rising dollar pushed crude prices lower. A report from the EIA showed an unexpectedly large gain in natural gas supplies and that knocked gas futures to a -8% decline. This depressed some energy stocks with a nat gas component even further. Fortunately Hess is not a big gas producer so the decline in Hess was minor.

The Russell ETF declined at the open to initial support and then rebounded slightly. If we see another decline like today we should see that support level broken.

The market rebounded about 50% from its opening lows on expectations of either a strong Nonfarm Payroll report on Friday OR a bad report that might cause the Fed to act. Another report in the 75,000 to 100,000 range would be seen as neutral and leave the market confused about direction.

We are still hostage to the headlines for at least one more day.

I updated the stop loss on IWM and highlighted the new stops in yellow in the portfolio graphic.

Current Portfolio:


CALL Play Updates

Health Care REIT - HCN - close: 62.18 change: +0.27

Stop Loss: 61.20
Target(s): 64.75
Time Frame: exit prior to the Aug 6th earnings
New Positions: see below

Comments:
08/02/12 update: HCN actually rallied today in a very negative market. If we had a couple more days to wait I feel we would see a higher move. However, earnings are Monday so we need to close the play at the open on Friday.

FYI: The Point & Figure chart for HCN is bullish with a $70 target.

- Suggested Positions -

Long Aug $60 call (HCN1218H60) entry $1.55

Entry on July 24 at $61.15
Earnings Date 08/06/12 (confirmed)
Average Daily Volume = 1.5 million
Listed on July 23, 2012


Hess Corp. - HES - close: 46.52 change: -1.28

Stop Loss: 45.35
Target(s): 49.85
Time Frame: 3 to 6 weeks
New Positions: see below

Comments:
08/02/12 update: Hess dropped with oil prices and the big drop in the broader market on the ECB disappointment. We need to see a move over 48.50 to trigger new buying.

- Suggested Positions -

Long AUG $47.50 call (HES1218H47.5) Entry $1.05

- or -

Long SEP $47.50 call (HES1222I47.5) Entry $2.02

07/26/12 triggered on gap open higher at $46.65

Entry on July 26 at $46.65
Earnings Date 07/25/12
Average Daily Volume = 4.3 million
Listed on July 25, 2012


Mosaic - MOS - close: 57.97 change: -.14

Stop Loss: 57.50 (Unopened)
Target(s): 67.00
Time Frame: 4-6 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
Mosaic is a fertilizer stock and its products are in high demand in normal growing seasons. This year we are experiencing a major drought that could impact crop yields dramatically and farmers are already plowing under corn fields and soybeans.

According to Citibank analyst PJ Juvekar the last two times in recent history when we had severe droughts (1983, 1988) the demand for fertilizer actually rose by +8% for phosphate and +2% for potash. Not being a farmer I can't tell you why but those are the facts.

Juvekar said Citi now prefers Mosaic to Potash (POT) over the next 12 months and sees a near term target of $66. MOS closed at $58 on Wednesday. The company has $3.8 billion in cash that could be used for share buybacks.

I have been watching MOS for a breakout to play it in another publication. There is strong resistance at $59.75 but I believe a positive market such as we might see from new ECB action will send buyers into Mosaic stock.

Shares have not declined since their earnings in mid July. Despite the bad market last week they held their gains. This underlying bullishness suggests a positive market could break through that resistance.

All the reasoning I have given above supports a longer term play than is normally suggested in these pages. However, I believe investors are looking at longer term fundamentals as they shop for stocks that can rebound in the next market move higher. Secondly I believe they will see the underlying strength in Mosaic as a position of safety in an unstable market. Mosaic just declared a 25 cent dividend and that attracts longer term buyers.

Trigger: Enter only with an MOS trade at $60.25

- Suggested Positions -

Position: Long Sept $62.50 Call (MOS1222I62.5), currently $1.62

Entry on UNOPENED xx at $ xx.xx
Average Daily Volume = 3.0 million
Listed on Aug 1, 2012


PUT Play Updates

United Rentals, Inc. - URI - close: 28.07 change: +1.29

Stop Loss: 30.55
Target(s): 23.00
Time Frame: 3 to 6 weeks
New Positions: Yes, see below

Company Description
Comments:
08/02/12 update: After a big decline of -1.13 yesterday URI saw a minor bounce even in a down market. Not a good sign. I still believe the market is going lower so we will keep the position open even though it showed relative strength today.

FYI: The Point & Figure chart for URI is bearish with a long-term $17 target.

Trigger: None

Positions

Long Sep $26 PUT (URI1222U26) @ $1.25

Entry on July 30 at $ 29.70
Earnings Date 07/17/12
Average Daily Volume = 4.4 million
Listed on July 26, 2012


iShares Russell 2000 ETF - IWM - close: 76.77 change: -0.28

Stop Loss: 78.50 (new)
Target(s): 75.75
Time Frame: 2-4 weeks
New Positions: Yes, see below

Company Description
Comments:
08/02/12 update: Surprising strength in the Russell at -2.54 on the day. The Russell had been leading the market lower and the morning dip in the IWM hit support at the July 24th low at 76.22. Evidently this support was enough to halt the decline on a temporary basis. I lowered the stop loss again to $78.50.

The target is a decline to the June support at $75.

Trigger: IWM at $78.85, hit at 11:40 AM on July 39th

Positions

Long Oct $78 PUT (IWM1220V78) @ $3.26, Stop $81.25 on IWM

Entry on July 30 at $ 78.85
Average Daily Volume = 60.0 million
Listed on July 28, 2012


Akamai Technologies - AKAM - close: 34.67 change: -.44

Stop Loss: 36.75
Target(s): 32.00
Time Frame: 2-4 weeks
New Positions: Yes, see below

Company Description
Comments:
08/02/12 update: The weak market finally weighed on AKAM and the stock declined to trigger our put play. Initial support at $34.25 is the next hurdle and a break there could see a sharp decline as traders take profits on the prior week's gains.

Why We Like It:
Akamai reported earnings of 43 cents last week that beat the street and raised guidance. The stock soared +25% on the news. That was on Thursday. Friday's market short squeeze failed to add any material gains to that spike BUT Monday's lackluster market also failed to produce a material decline in AKAM.

After a 25% spike well above the consolidation range of the last three months you would expect the spike to fade and profit taking appear. The raised guidance is probably what is holding shares up. However, if the Nasdaq begins to roll over on less than expected help from the ECB/Fed then profit taking could begin with a vengeance.

This is a high risk play. If we do get a dip to trigger our put entry and the market turns around the dip in AKAM could be seen as a buying opportunity.

I am looking for AKAM to retrace about half of its gains from last week if profit taking appears.

I am recommending we buy the Sept $34 put in anticipation of a possible decline to the June support at $32.

Trigger: Enter at $34.85 hit on 8/2 at the open.

- Suggested Positions -

Position: Long Sept $34 PUT (AKAM1222U34) @ $1.53

Entry on Aug 2nd at $ 34.85
Average Daily Volume = 3.0 million
Listed on July 30, 2012