Getting Carried Away (SPY,IEF,PFE)
There’s a concept in statistics that’s regularly applied to markets called ‘mean reversion’. It’s a rather simple idea, that anytime numbers get too far stretched from their long-term historical norms – either too high or too low – they eventually snap back.
And it has proven itself long enough to be relied upon by market analysts for at least a half century. Simply put – a market is in danger of a whiplash reversal when it strays too far from its mean. Forewarned is forearmed.
The only problem with the concept is that no one can know what any security’s ultimate breaking point is.
That is, how long will buyers continue accumulating in the face of what’s obviously a clownsuit of a market with a diamond studded price tag?
And how long will they continue to sell after it’s clear to all that stocks are available for mere pennies on the dollar?
And the truth is no one knows.
Human psychology is the intangible here. The ability of an otherwise rational individual to be swept up with the prospect of becoming filthy rotten rich overnight is not a sentiment to be underestimated. It leads many to cruise the seas in search of gold and engage in capers they might otherwise steer far from.
So, too, beware of that same individual’s propensity to unload his farm, car, even family and sanity for virtually free in a race to get something – anything – in return for them.
What happened to your brain, Jack!?
We’re no longer dealing with whole people in the investment realm today. The indexes are all flying higher daily, the Dow is adding a new thousand every Wednesday, and it’s all attributable to this hour’s preferred fund flows and sentiment. There’s literally nothing else there.
A few months ago we couldn’t buy a one percent move either way from the equity market. And today? It’s daily at least a one percent higher.
With no end in sight.
Take, for example, a look at the following chart of Pfizer Inc. (NYSE:PFE) –
Pop goes the measles!
You’ll remember that we put on a Pfizer trade back on the 19th of December in a letter called The Kids Are Alright. There, we urged you to consider buying the PFE September 2018 37 CALL for $1.95 and selling the PFE September 2018 37 PUT for $2.08 for a total credit of $0.13.
The CALL trades for $3.03 and the PUT for $1.49. Sell off the former and buy back the latter and you net $1.67 on nothing down. Adjusted for minimal commissions gives you a return of 1013% in a short six weeks.
And Pfizer’s not alone.
All across the market we’re seeing equally spectacular moves from old-line fuddie-duddies (like Pfizer) as well as the latest sexy tech plays. And not just domestic stocks are moving, either. A look at the Chinese market shows a complete lack of acrophobia in Shanghai.
And from China to the commodities, where the NYMEX natural gas contract, represented by the U.S. Natural Gas Fund (NYSE:UNG), exhibits an even wilder climb.
And to us it all indicates that we’re swiftly approaching the end of this leg up for the bull.
Egregiously manic moves across the investment spectrum is a symptom of an unhinged buying cohort. Full stop.
So How Do We Play it?
Without knowing for how long we’re going to be locked in this upward spiral, there are two opportunities that lie before us. The first, more predictable option, is to bet on the surge continuing, staying long the broad market, or at least the leading stocks, and holding on for dear life.
The other option, which is more profitable – if somewhat more difficult to time – is to bet on the turn. A straight PUT purchase in times of low volatility stands to profit far more dramatically than nearly any other strategy should the markets turn meaningfully lower and volatility erupt.
Our trade for the week is a sort of combination of the two, but involves two distinct sectors of the market that we believe are destined to shoot in entirely different directions should an equity selloff of an even modest five to ten percent occur.
So we’ll begin with this…
As of late, the bond market has been under strong pressure. Not only have economic growth numbers fortified the need for higher interest rates, but a consensus is building that the bond bull that began in 1980 is about to breathe its last. The end of easy money is becoming increasingly tangible, and that’s leading to bearish sentiment in the bond pits.
But wait a dog-gone minute!
On the one hand, we’ve seen rates on the 10 year and long Treasury bond break below resistance, and on the other, we’ve seen traders begin to take the short side of the major corporate bond ETFs.
Have a look –
It’s the speed and size of the switch from long to short that’s caught our attention. In just over a week, positioning in LQD, the largest investment grade corporate ETF has swung dramatically. There was virtually no short interest on the stock after New Year’s. And now we’re approaching 52 week highs.
The melt-up in short interest has come hand-in-hand with the meltup in stocks, and we believe both sides are mistaken in their enthusiasm. Positioning is way too extreme and plainly calls for a reversal in the near term.
And that’s the setup for this week’s venture.
We’re using the iShares 7-10 Year Treasury Bond ETF (NYSE:IEF) against the SPDR S&P 500 ETF (NYSE:SPY) to execute the deal.
This is the way they chart against each other since August.
It’s overbought against oversold.- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
Wall Street Elite recommends you consider purchasing the IEF June 15th 105 CALL for $0.70 and selling the SPY June 15th 310 CALL for $0.75 for a total credit of $0.05.- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
With kind regards,
Hugh L. O’Haynew