Weekly Options Recap

Amazing Two Month Turnaround!

Wow, another strong week with the broad market (S&P 500) advancing a whopping 5.9%! That brings the Year to Date performance on the index into positive territory, now at 2.9%. That is an amazing turnaround from the market lows hit on March 9. Over the past two months, the broad market index has risen an incredible 37%, for what is surely one of the best two month performances in stock market history. To many of us, it feels like the worst is over for the stock market, and recent money flows into the market would support that. Late March and April cash inflows were at their highest percentage levels since 2003, which coincided with the start of our last bull market. Net cash inflows are highly correlated with stock market performance, as inflows drive up demand for stocks and prices follow suit. For this recession, we do think that the March lows may turn out to be the stock market bottom. However, we also know that the market cannot sustain 30% plus gains every two months for the remainder of this year. Do not be surprised if there is a bit of a pullback or market consolidation over the next few months. In fact, it might be healthy to see the market take a breather over the near term. However, we suspect there is still a great deal of money on the sidelines that will eventually enter the stock market. Those inflows have the potential to drive the market significantly higher. Our only concern is that the stock market may be getting a little ahead of itself, as the economy is still in decline as we discuss below.

Rate of Decline is Slowing!

Has the recession hit bottom? The evidence suggests that the recession is still very much in force. Most economic measures are still declining, although the rate of that decline has indeed slowed significantly. That slowing rate of decline is what has most investors excited. For example, most manufacturing activity still shows contraction and the unemployment rate continues to rise, although jobless claims did come in lower than expected last week. Measures on GDP continue to show declines, although that rate (pace) of decline is slowing. Housing measures are still very poor and a bottom still appears elusive. However, it is fair to say that the economic news and forecasts today are less bad than they were a few months ago. Those are encouraging signs that we too think are positive. However, we do not think we will see the end of the recession until later this year. In fact, we think unemployment will continue to rise through the end of this year. Real economic growth and job creation may not reverse trend and start upward until 2010. However, the stock market is considered a leading indicator on economic measures, with past history suggesting it will lead the economy out of recession by 6 to 8 months. If March was the bottom that would suggest economic trends will turn positive by the end of the fourth quarter this year. While it will take time for the economy to reverse trend, the stock market has already begun its march upward. The other big news last week was the financial sector. The government released the bank stress tests, and results were better than the market expected. The financial sector exploded, rising more than 23% in one week alone! Also, the 1st quarter earnings season is now winding down. All in all, corporate earnings have come in mostly better than expected, although they are down from prior years. On the other hand, companies have not done as good a job meeting revenue expectations, which we view as a reflection of just how poor the economy really is.

Option Tips For Investors!

We expect the market (S&P) to swing between a trading range of 875 and 975 over the near term in what may remain choppy trading. We also expect volatility (VIX) to trade between 28 and 38 over the next month, mostly in the low 30 range. The volatility or fear gauge has been trending down which is a good sign for investors. However, there is still downside risk given the fragile economy and uncertain corporate outlook, although that risk has been decreasing. Quarterly earnings for the most part have been better than expected, although revenue expectations have fallen short for a majority of companies. Earnings are easier for companies to manipulate over the short term than revenue, with the later perhaps a more objective measure of the long term business health. Lower revenue expectations are a sign to us that the economy is having a more negative impact on companies that initially expected. That leads us to believe that the recovery may take longer than expected. Our primary options strategy is to buy long call options on stocks that hit our Momentum and Value screen. Given the rocky market since November, that strategy has been pretty much on hold. However, with the recent market strength and growing investor optimism, we have begun to invest in this strategy again. We are not ready to go all in on options, but do plan to increase our allocation on long call options over the near term.