The Next Wave Higher (XLF, SPY)

We’ve spoken a number of times in the past about the advantages and use of technical analysis in the study of markets. And we’ve also discussed the limitations that we currently face using those same tools as we attempt to navigate what we believe is an unprecedented market reality – one of global super-hyper-liquidity.

wipeout

[click on image to listen]

Truth is, we’re not so sure the term ‘super-hyper-liquidity’ genuinely captures the essence of the existing and potential number of dollars (and Euros and Pounds and Yen and Renminbi, etc.) that are floating about the world’s financial system. We might have to add another ‘super-duper’ or ‘mega-colossal’ to actually do the idea justice.

Have a look here –

chart69
This is a chart you’ve no doubt seen many times before. It’s the U.S. money supply charted for the last 100 years, and it gives a reasonable graphic depiction of what we’re trying to convey. Let every liar, swindler and cheat now step up and tell you that it’s all business as usual and that we’re not facing something qualitatively different than we have in the past. In a ninety-year timespan, the money supply grew at a relatively even pace, and then, in all of five years, it was magnified by a factor of five – and it’s still growing!

And remember, too, that this is just the chart for the U.S. The Chinese central bankers have nothing to learn from us on the money-printing front, and the Japanese and Europeans are proving precocious students, too.

In our opinion, the system has received in the last five years the economic equivalent of a baseball bat to the head – or a hundred hits of LSD, depending upon your worldview.

But how exactly will it affect technical and fundamental analysis?

How exactly, we can’t say. As for the fundamentals, you should be prepared for stretched multiples on every front, from cash flow to earnings to book value and everything in between. There is no number that will be posted that Wall Street won’t tell you could get bigger – and deserves to be so. And they’ll be right, in a manner of speaking. Because the very fact of an outsized ocean of liquidity will mean, by definition, that stocks can and will move higher. And woe to the analyst or strategist who says the party’s over before it actually is.

A Self-Feeding Loop

Keeping with the fundamentals, we expect those companies that miss earnings expectations to be given a slap on the wrist, at first, and those who meet or exceed analysts’ forecasts to get full-on ticker tape parades. We say ‘at first’, by the way, because we also expect a gradual winnowing of the market, whereby the focus and hype will eventually aggregate about a relatively short list of mega caps (and a few other sexy numbers) that will come to absorb most of the dollars headed toward equities, pushing the major indexes higher, while the less popular names slowly lose momentum and drop off the radar.

But we’re not there yet. The market is still offering a patina of normalcy. And despite all the cash sloshing around, we haven’t yet hit the manic stage of this mother of all widow-making, blow-‘em-up and drag-‘em-out bull markets.

And what about the technicals?

As to the charts, it’s also hard to say how they’ll be affected. There will certainly be less to trust from the ‘overbought’ indicators, like RSI 80 readings, volume surges, asymptotic price rises, record MACD divergences and the like. We’ll just have to get used to these indicators being stretched and trust our instincts and our proprietary composite indicators to give us a fuller picture of the strength of the bull.

We don’t expect sentiment indicators will be so trustworthy in the end, either. We believe that they’ll register too bearish now, as the rest of our indicators repeatedly show the market to be overbought, and then too bullish later, as everyone realizes that the traditional gauges and markers of froth are no longer so reliable.

On the downside, however, we expect technical readings to be very sensitive to pullbacks, and for rebounds to occur well before typical oversold ‘bottoms’ are registered. The sheer quantity of money waiting to redeploy will be the determinant here – a phenomenon that will halt declines early and make advances larger than usual.

In effect, it’s already happening. As the chart below shows, we haven’t seen a ten percent pullback in more than two and a half years.

waiting

And yet for many an investor that’s precisely the starting gun he’s waiting for, the definitive ten percent ‘correction’ that will let him reenter the market and let him feel like he got in on the cheap.

Yet as the chart also shows, that ‘correction’ has yet to transpire, leaving Joe Q. Public out in the cold, still waiting, as the market gets more expensive daily, and he loses a tremendous amount of money sitting in bank certificates and short term Treasury Bills.

A monster! – You’ve created a bloody monster!

Yes, indeed, that’s what we’ve got. A monster that we continue to play for fun and profit.

So here’s a trade.

Background: while the indexes are daily hitting new highs and everyone is anticipating the Dow at 17,000, we have our eyes turned toward a sector that’s not kept pace over the last few months. It’s a group that we fully expect to go turbo-charged before the bull has breathed its last, but today its fuse has yet to be lit.

Let’s take a look at it now – the financials, as represented by the Select Sector SPDR Financial ETF (NYSE:XLF).

xlf69

Here we have a sector that’s been rising very gradually, with both moving averages and trade volumes steady for the last half-year (in blue). Only last Friday, however, did XLF manage to set belated highs – as compared to six new highs for the S&P 500 that have been racked up over the last two weeks.

That notwithstanding, the stock is outright bullish but could be approaching a danger zone if RSI readings continue to climb (at bottom, in black).

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All things considered, however, we believe the financials will now outperform the broad indexes, yet we’re going to play the trade using options.

We’re going to pair XLF with the S&P500 and bet on the former outperforming.

Wall Street Elite recommends you consider the following trade – buy the XLF September 21 CALLs for $1.99 and sell the SPY September 200 CALLs for $2.08, for a credit of $0.09 per pair traded.

XLFs are already 8.6% in-the-money. The SPYs are 2.3% OTM.
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All things considered, however, we believe the financials will now outperform the broad indexes, yet we’re going to play the trade using options.

We’re going to pair XLF with the S&P500 and bet on the former outperforming.

Wall Street Elite recommends you consider the following trade – buy the XLF September 21 CALLs for $1.99 and sell the SPY September 200 CALLs for $2.08, for a credit of $0.09 per pair traded.

XLFs are already 8.6% in-the-money. The SPYs are 2.3% OTM.
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With kind regards,

Hugh L. O’Haynew
Senior Analyst
Normandy Research

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