Option Investor

Daily Newsletter, Thursday, 7/8/2010

Table of Contents

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

Market Wrap

Stocks Extend Their Gains

by James Brown

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The third-quarter rally continues. Stocks have continued to rebound sharply during this holiday shortened week with the S&P 500 up nearly +4.7%. It's the first three-day rally since April and the Dow Jones Industrial's best three-day rally since May. Positive comments out of the IMF regarding global growth and better than expected weekly jobless claims in the U.S. helped fuel the move. Plus, yesterday's positive earnings guidance from State Street Bank (STT) helped set the tone (officially STT reports earnings on July 20th). This morning's June retail same-store sales numbers didn't have much effect on the market but the RLX retail index did post a very minor loss. At the end of the day the bond market ticked lower with the ten-year bond yielding just over 3%. Gold slipped almost $3 to $1,196 an ounce. Crude oil rallied 1.8% to $75.44 a barrel thanks to the IMF's positive comments on global growth.

Foreign markets were mostly higher. Europe was performing well, which probably had a bullish influence on Wall Street this morning. Positive earnings reports in Europe and bullish analyst calls on the banks fueled gains. Germany reported strong trade numbers for the month of May, which suggests the second quarter could have seen a big improvement for Europe's largest economy. Meanwhile the Bank of England and the European Central Bank both left interest rates unchanged at 0.50% and 1.00%, respectively, which was what the market expected. Investors are growing less fearful of Europe's problems if the rally in the euro currency is any indication. The euro is up sharply from its June 29th low and closed at new seven week highs.

Fueling that optimism in Europe has been the banking sector. Aside from positive analyst comments investors are hoping for good news from the stress tests. It looks like results from the stress tests are still two weeks away but the market is betting that the results will show banks are in a much better position than previously feared. The Committee of European Banking Supervisors is conducting the tests and revealed that over 90 banks are participating. There are plenty of conspiracy theorists out there who believe these tests are a farce and designed so that none of the banks fail. Given the lack of details behind this stress test it certainly fuels the rumor mill.

European Central Bank President Jean-Claude Trichet said that the euro-zone's economic rebound will be "moderate" and "uneven". That's not a surprise. You could say we're dealing with two Europes. France and Germany, the EU's largest economies, while on the edge of a double-dip recession, might be able to claw their way higher. Yet most of southern Europe remains in an ugly recession and given the strict austerity measures they probably won't see any significant growth for years. Overshadowing Trichet's comments today was the IMF, who updated their 2010 forecast. The IMF now expects global growth this year to hit +4.6%, up from +4.2%. That would be the strongest pace since 2007. IMF attributes the gains to a strong Asia and the big bounce we've seen in the U.S. The report did point out that Europe's debt crisis remains a big risk to the global economy. Thursday's session saw the German DAX index gain +0.7%. The French CAC-40 rose +1.57%. The English FTSE rallied +1.8%. In Asia the Chinese Shanghai index lost -0.25%. The Hong Kong Hang Seng rose +0.9%. The Japanese NIKKEI outperformed with a strong +2.7% rally.

The Thursday morning weekly initial jobless claims numbers are not normally a market moving event, especially since this data has been stuck hovering near the 450,000 level for several weeks in a row. Yet the market chose to react to today's report. The Labor Department said new unemployment claims fell -21,000 to 454,000. Estimates ranged from 465,000 to 458,000. The four-week moving averages remains very high at 466,000. The number of people on continuing unemployment claims plunged -224,000 to 4.41 million. This is a 20-month low but I strongly suspect this number is shrinking because workers are exhausting their unemployment benefits and are no longer being counted.

The market is desperate to hear good news about the consumer. Unfortunately the June same-store sales numbers were a disappointment. Several major retailers reported their same-store sales data and the results were very mixed. A few companies managed to see improvements but they were not high enough to beat Wall Street's estimates. Over half of the companies reporting same-store sales data missed expectations. That's not a healthy sign. Stores reported more traffic because the East and West coast recorded above average temperatures, which led consumers to spend more time indoors thanks to air-conditioned malls. Yet higher traffic did not translate into higher sales. To make matters worse June and July are normally clearance months for retailers with big discounts. Thus any sales they did ring in at the cash register probably saw smaller margins. The retail sector could end up being an under performer through the second half of 2010. Comparisons to last year have been easy to beat but once we get past July it's going to be a lot harder for retailers to post year-over-year gains.

A big clue to consumer spending and the trouble retailers face is the trend in consumer borrowing. The Federal Reserve said consumer borrowing plunged $9.1 billion in May. Economists were expecting a drop of $2.3 billion. The Fed also adjusted April's numbers from +$995 million to -$14.9 billion. Consumer borrowing has been in a steep decline with borrowing down 15 out of the last 16 months. Americans are worried about their job security so they are spending less and paying down debt. Long-term this trend of Americans paying down their debt is great! Too many of us were living beyond our means. Unfortunately, the more money we use to pay down debt means less money to spend elsewhere and that's going to keep the brakes on our economic recovery.

On top of consumers borrowing less we also have an environment with banks remaining strict on their lending standards. That's why record-low mortgage rates are unlikely to help the U.S. housing market. This morning 30-year mortgages fell to an all-time low of 4.57%. Freddie Mac has been tracking rates since 1971 and this is the lowest on record. According to Reuters the last time rates were lower than this was back in the 1950s but home loans were only 20 or 25 years long. Anyone who was thinking of buying a house in the near future probably rushed to take advantage of the now expired federal tax credit. Many homeowners who would like to refinance are underwater on their mortgage or their less than stellar credit doesn't meet the bank's new standards. The Mortgage Bankers Association said mortgage applications rose from a week ago but are down -35% from a year ago.

Looking at the major market averages I think this bounce is a trap. Stocks don't move in a straight line, at least not for very long. The market was very short-term oversold following a two-week plunge. This is just an oversold bounce. I warned readers in my weekend commentary (LeapsTrader) that bear-market rallies tend to be very fast and sharp, just enough to sucker in the bulls only to reverse again. Now officially the S&P 500 is not in a new bear market but the breakdown under 1040 last week caused significant technical and sentiment damage.

Chart of the S&P 500 index:

The +4.7% bounce in the S&P 500 is nice but there is still a lot of congestion near the 1080 level and if the rebound continues there is a lot of resistance near 1100-1110 and the 200-dma. Thus far the S&P 500's rebound over the past three days has stalled near the 50% retracement of the two-week decline. The 61.8% Fib retracement is close to the 1085 level. Short-term traders may want to look for the failed rally to launch new bearish positions.

Intraday Chart of the S&P 500 index:

The NASDAQ is in a similar situation with the tech-heavy index producing a nice bounce but still under key resistance. The 2200 level and the top of the gap from June 29th near 2,220 could both be resistance. Plus the NASDAQ could have technical resistance at its 50-dma and 200-dma.

Chart of the NASDAQ index:

The DJIA's rebound has been just as sharp with a 5% bounce but this index is also facing plenty of overhead resistance on top of its bearish trend of lower highs and lower lows.

Chart of the Dow Industrials index:

The small cap Russell 2000 index has produced a similar bounce (+5%) but it has fallen a lot farther than its big cap peers. I would expect the $RUT to find resistance in the 625-650 zone.

Chart of the Russell 2000 index:

Looking Ahead:

I can't tell you exactly when this oversold bounce is going to fail. The levels identified above are a good place to start. However, earnings season will begin soon. Dow-component Alcoa (AA) officially kicks off earnings season when it reports earnings on Monday after the closing bell. There is a possibility that better than expected earnings news sends stocks higher. All it takes is a few key reports or strong earnings guidance from management and we could see shorts rush to cover. Unfortunately, that is not a bet I would want to make. Thomson Reuters estimates that S&P 500 earnings will rebound +27.1% in the second quarter (from a year ago). Compare that to +58.1% we saw in the first quarter.

If you see the glass as half full then I would be encouraged that Wall Street seems to have brought down some of their estimates. That is especially true in the banking sector. If analysts continue to lower their estimates it gives the market a better chance to beat the numbers and fuel another rally in stocks. However, keep in mind that the third quarter is normally a weak period for stocks. I would expect the second half of July to be challenging. Tomorrow we'll get the wholesale inventory report but I'm not expecting it to be a market mover. Odds are tomorrow will be a typical summer Friday, which means low volume.

- James

New Option Plays

Short Play In Retail

by Scott Hawes

Click here to email Scott Hawes


Polo Ralph Lauren - RL - close 77.72 change +2.26 stop 82.50

Company Description:
Polo Ralph Lauren Corporation is engaged in the design, marketing and distribution of products, including men’s, women’s and children’s apparel, accessories, fragrances and home furnishings. The Company operates in three segments: Wholesale, Retail and Licensing. Apparel products include collections of men’s, women’s and children’s clothing. Accessories include a range of footwear, eyewear, watches, jewelry, hats, belts and leather goods, including handbags and luggage. Home products include bedding and bath products, furniture, fabric and wallpaper, paint, tabletop, and giftware. Fragrance products are sold under its Romance, Polo, Lauren, Safari, Ralph and Black Label brands, among others.

Target(s): 75.25, 73.50, 72.10
Key Support/Resistance Areas: 82.00, 80.00, 78.00, 75.00
Time Frame: 1 to 2 weeks

Why We Like It:
RL has rallied +8% off of its lows on Friday and is now approaching its 20-day SMA, two downtrend lines, and a price congestion dating back to October 2009, all from below. The facts are that the consumer is not in good shape, jobs are hard to come to come by, and the housing market remains in the tank. This doesn't bode well for retailers and I believe we will see RL retest its lows before it breaks the downtrend lines. I've chosen $77.40 as the entry trigger which is just above today's closing price. I would like to buy August $75.00 PUTS for no more than $3.00 which is what they should be worth at $77.40. Our stop will be $82.50 which is 20-day and 200-day SMA's and will be below the 50-day SMA in a matter of couple of days. NOTE: Trading in the August contracts is a bit light because the strikes for August were just opened for trading recently.

Suggested Position: Buy August $75.00 PUTS if RL trades to $77.40, current ask $3.10, estimated ask at entry $3.00

Annotated chart:

Entry on July xx
Earnings 8/5/2010 (unconfirmed)
Average Daily Volume: 1.8 million
Listed on July 8, 2010

In Play Updates and Reviews

Call Play Closed For Nice Gain

by Scott Hawes

Click here to email Scott Hawes

Editor's Note: Good evening. I wasn't able to write specific updates this afternoon so I have provided comments below on our positions. The recent bounce in the market is certainly testing our will in some of our short positions. However, there should be enough overhead resistance to keep bounces under control if it continues. The SPX sits at 1,070 which is the 50% retracement from the June 21 highs. The 20-day SMA is also just overhead at 1,076 and then the 61.8% retracement at 1,085. And last but not least, the primary downtrend line from the April highs runs right through the aforementioned levels. If the SPX stops at any of these levels it should make a lower high and proceed to at least retest last week's lows. Of course the wildcard is earnings season beginning next week which could change everything. I expect trading to be very choppy as earnings season gets underway next week so I am trying to keep realistic profit targets and book quick gains. Please email me with any questions.

Position Comments:
Long AGN - The stock hit all of our targets this morning and our call position was closed at $4.20 (entry was at $3.10). Our gain was +35%. I will post the closed update tomorrow.

Short DE - This the only position I am concerned about currently. It has moved against us the last 2 days. The stock is still below its 20, 50, and 100-day SMA's and closed right on its downtrend line from the 6/21 highs. I am expecting the stock to run into resistance and reverse lower soon.

Short IR - We were triggered on our short entry at $34.30 and that's just about where the stock closed.

Short LULU - We were almost triggered this morning and are waiting patiently.

Short QQQQ - We were triggered at our entry of $44.30. The stock closed at $44.20.

Short SBUX - We were triggered at our entry of $24.75. SBUX closed at $24.84.

Current Portfolio: