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How to Play the Market's Next Move

Last week’s article was intended to alert you to a potential looming market movement.

Readership response was varied. There were both positive and negative reactions to what I said.

• Some of you wanted to know my answer to the question of whether that movement will be “up” or “down.”
   
• Some of you wanted to know how I was preparing for this impending movement.
   
• There were even several of you who were puzzled that I would wait a week to give my answer.

Today, I will give my opinion on market direction and the elements that pertain to my decision-making process and results.

My answer to the question of whether the market will go up or down is ... yes! The market will go up first, then down.

It's All About the Earnings Right Now

We just started earnings season, and I am sure most of you know that, by and large, the earnings reports will definitely beat estimates.

However, within those seemingly positive earnings are unusual elements that, in my mind, do not translate to a healthy, sustainable economic recovery or market rally.

Earnings Artificially 'Stimulated'

First is the fact that this past quarter was boosted by stimulus packages including Cash for Clunkers, the First-Time Home Buyers Tax Credit and a ton of stimulus package money used for infrastructure.

Did you notice all the road work going on in the late summer? States had to put that stimulus money to work before the end of September or else lose it. The third-quarter round of earnings was stimulus-supported.

A 'Cut' Above

Second is the fact that, within the earnings, another round of strong cost-cutting was evident. Even Alcoa’s (Symbol: AA) numbers showed a better net from lower sales.

Whenever a company reports higher earnings off lower sales, it is most likely due to cost-cutting. Many company-watchers believe that these cost-cuttings are a positive thing. They believe that this will make U.S. companies stronger and more efficient -- which, in turn, will lead to a more-competitive United States in the future ... ready to compete in the upcoming, new global economy.

They may be right ... but not for a long, long time.

The problem is that there can be only so many quarters of cost-cutting until there are no more costs to cut. Then, no longer able to show better earnings by lowering costs, companies will need to increase earnings to sustain “expected earnings growth.”

That is the point where we will face trouble.

Are Expectations Realistic?

Finally, we need to talk about Wall Street estimates. Last quarter, Wall Street lowered estimates to ridiculously low levels, and companies beat them handily. This quarter, Wall Street put out some low estimates again.

I fully expect many companies will beat estimates and, based on that, the market will go up again. Therefore,  I did not feel I had to be in a rush to tell you what I thought last week. … I knew we had time to set up our hedge, which I will cover later.

For those who want to get a hint toward the future of earnings, start watching how the Wall Street estimates change from quarter to quarter. If there is real quarter-to-quarter earnings growth going on -- as there should be in a truly recovering economy -- then we should also see the Wall Street earnings estimates grow quarter to quarter!

Where Will We Be By Q4?

If the estimates are not growing quarter-to-quarter, then the economy is not recovering.

This is why I believe that it is the next two earnings seasons, not his one, that will tell the tale. Keep your eyes on estimated growth.

Now, I do agree with the reader who thought that the eventual market direction is painfully obvious. In my opinion, there is a problem ahead.

But with all the forward-coming problems that will weigh on the market, the market is going up!

It has been going up, it is going up now, and it will continue to go up for a while longer.

Technically Speaking...

Technically speaking, this market is in a classic uptrend. It has been trading above the 50-day simple moving average (SMA) and, just last week, bounced up strongly off the 50 after trading down to it the week before.

The bounce up confirmed the technical uptrend.  Had there been a breakdown through the 50, it would have confirmed the reverse.

Right now, the government -- with Wall Street’s help -- has created a perception of improvement and recovery.

The truth is, the battle is really between the government’s ability to convince us of their reality, and our ability to perceive the true (but obscured) reality. Eventually, I think the true reality will win.

Right now, however, I believe that the market is trading irrationally. What we need to realize is that the market can stay irrational longer than you can stay liquid.

So, although the market is sure to go down (I think!), it may not go down for some time yet.

And while we are in this uptrend, we must -- no matter our opinion -- ignore where we feel it should be, and be long!

So, What Do We Do Now?

Well, first of all, we can be patient while the market trades comfortably above the 50 day SMA. I suggest beginning to replace all of your long stock positions with out-month, in-the-money options. Using longer-term options, or LEAPS -- expiring in January 2011 or another expiration month in late 2010 -- will be fine.

I would replace the stock with options in a 1-to-1 ratio. This means for every 100 shares, buy one call and sell the stock out.

The calls should perform similarly to the stock on the way up but, on the way down, the call will not lose anywhere near what the stock would lose.

What you have done here is to lock in profits, and decrease your risk dramatically by removing a good deal of money from the market, thereby decreasing your exposure.

How to Play a Pullback

My next step would occur if and when the market trades back down to the 50-day SMA again. A second test of the 50 brings with it a better chance of breaking down and through.

So, this time, the purchase of some three- or four-months-out out-of-the-money puts in the Diamonds (Symbol: DIA), the S&P 500 SPDR (Symbol: SPY) or the Nasdaq-100 Trust (Symbol: QQQQ) would provide a little protection in case this test of the 50 is the big one!

Don’t get crazy on the size of the put purchase ... this purchase is designed to take the sting out of an opening gap down below the 50 ... not to fully hedge the portfolio.

From  there, if we get technical confirmation of the breakdown (i.e., the stock closing below the 50 one day and then down the next day), we can get a little more aggressive on our index ETFs. This time, we can look a little more toward front-month options and those that are a little closer to at-the-money (ATM).

Again, do not overdo it. Remember, as the stocks go down, your calls will lose less and less money as they lose deltas, while your protective puts will make more and more as the market goes down and the puts gain deltas.

By not overdoing it, you still have a chance of making money if the market does support again at the 50-day SMA and bounces up!

Now, if the market does bounce back up off the 50, then our trigger to add more puts would occur under two conditions:

• If this latest bounce off the 50 does not go up as high as the last bounce (lower high), or
   
• If the bounce goes above the last high but quickly reverses and trades back down below it (failed new high).

If either of these two scenarios occurs, the market likely will trade back down to the 50 for a third test. Most of the time, the third test has a much-higher chance of failure.

As they say, there is no such thing as a triple-bottom!

So, we can get more-aggressive on the lower high or the failed new high instead of waiting for the third test of the 50.

Hopefully, I have provided enough information here (and made it clear) as to my thought processes and resulting actions depending on the way the market goes over the next few months.

Be aware that, in order to make money, you must respect where the market is going regardless of where you think it should go. Your contrary opinion should be reflected in the scope and depth of your hedge ... not in the structure of your portfolio!

Next week, I will run through my thought process and actions in response to the market finally and inevitably breaking down below the 50 and beginning a new next wave down!




Ron Ianieri
Chief Investment Officer
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WEDNESDAY, OCT. 14   

8:30 a.m. Retail Sales

    * Importance (A-F): This release merits an A-.
    * Source: The Census Bureau of the Department of Commerce.
    * Release Time: 8:30 a.m. Eastern around the 13th of the month (data for one month prior).
    * Raw Data Available At: http://www.census.gov/svsd/www/advtable.html

The retail sales report is a measure of the total receipts of retail stores. The changes in retail sales are widely followed as the most timely indicator of broad consumer spending patterns.

Retail sales are often viewed ex-autos, as auto sales can move sharply from month-to-month. It is also important to keep an eye on the gas and food components, where changes in sales are often a result of price changes rather than shifting consumer demand.

Retail sales can be quite volatile, and the advance reports are subject to rather large revisions. Retail sales do not include spending on services, which makes up over half of total consumption. Total personal consumption is not available until the personal income and consumption reports are released, typically two weeks after retail sales.

Highlights

    *The Cash for Clunkers stimulus plan boosted retail sales in August. Auto sales increased 10.6% in August and pushed sales up 2.7%. Consensus only expected an increase of 1.9%.

    * Excluding autos, sales rocketed 1.1% after falling 0.5% in July. Consensus expected a more-modest increase of 0.4%.

    * Strong growth was recorded: electronic store sales (1.1%), food and beverage sales (0.5%), health and personal care stores (0.4%), gasoline stations (5.1%), sporting goods and hobby stores (2.3%), and miscellaneous store retailers (0.2%).

    * Only furniture stores (-1.6%) and building materials and garden equipment stores (-1.2%) posted monthly declines.

    * Core sales, which exclude auto dealers, building materials, and gasoline stations, posted its first month-over-month increase in five months with sales growth of 0.7%. The trend in core sales is used to project the consumption component in GDP and the rebound in core sales suggests an increase in personal consumption expenditures in Q3.

Key Factors

    * A large contributing factor to the increase in sales was a tax holiday issued to help households with back-to-school purchases. We can see some of these gains in the clothing sector, which increased 2.4% in August after increasing only 0.2% in July, and general merchandise stores, which posted a 1.6% gain in sales after falling 0.3% in July.

    * Sales in these areas probably will not hold up in September.

Big Picture

    * Retail sales fell off dramatically starting in September.  That was when the financial markets fell apart and the news became apocalyptic.  Auto sales rebounded due to the Cash for Clunkers stimulus plan, but is expected to remain depressed over the next several months.  Retail sales are likely to remain weak for quite a while given the current trends in employment, and the negative wealth impact for depressed prices for homes and stocks.


THURSDAY, OCT. 15

8:30 a.m. CPI: Consumer Price Index

    * Importance (A-F): This release merits a B-plus.
    * Source: Bureau of Labor statistics, U.S. Department of Labor.
    * Release Time: 8:30 a.m. Eastern, about the 13th of each month for the prior month.
    * Raw Data Available At: http://stats.bls.gov/news.release/cpi.toc.htm

The Consumer Price Index is a measure of the price level of a fixed market basket of goods and services purchased by consumers. CPI is the most widely cited inflation indicator, and it is used to calculate cost of living adjustments for government programs and it is the basis of COLAs for many private labor agreements as well.

It has been criticized for overstating inflation, because it does not adjust for substitution effects and because the fixed basket does not reflect price changes in new technology goods which are often declining in price. Despite these criticisms, it remains the benchmark inflation index.

CPI can be greatly influenced in any given month by a movement in volatile food and energy prices. Therefore, it is important to look at CPI excluding food and energy, commonly called the "core rate" of inflation. Within the core rate, some of the more volatile and closely watched components are apparel, tobacco, airfares, and new cars. In addition to tracking the month/month changes in core CPI, the year/year change in core CPI is seen by most economists as the best measure of the underlying inflation rate.

Highlights

    * The CPI index rose slightly more than expected at 0.4% in August. Consensus forecasted a rise of 0.3%.

    * Over the last 12 months, prices have declined 1.5%. We expect a reversal in the year-over-year numbers shortly due to the run-off from last year's oil price spike.

    * Excluding food and energy, core CPI rose a much more modest 0.1% month-over-month and is only up 1.4% year-over-year. The CPI continues to be below the Federal Reserve target inflation rate of 2.0% to 2.5%.

    * New vehicle prices declined 1.4% month-over-month due to the Cash for Clunkers stimulus check. The decline in new vehicle prices was offset by a sharp rise in used vehicle prices of 1.3.%.

    * In other sectors, price increases were found in food and beverages (0.1%), housing (0.1%), transportation (2.3%), medical care (0.3%), recreation (0.1%), education and communication (0.2%), and other goods and services (0.1%). The only sector where prices declined was apparel, which fell 0.1%.

Key Factors

    * The economy is still in a deflationary environment. The increase in CPI was not due to a broad-based jump in prices, but due to continued fluctuations in the oil market passed through to energy prices as the energy index rose 4.6% after declining 0.4% in July.

    * Until consumer demand rebounds price growth will remain weak.

Big Picture

    * Inflation trends have weakened.  The decline in energy prices after the last summer's spike has taken CPI down to -2.1% on a year-over-year basis as of July 2009 data.  Energy prices have again increased, yet the core rate should ease due to weak demand.  Low inflation rates are likely to continue through 2009 although continued month-over-month deflation is not likely.


10 a.m. Philadelphia Fed Index

    * Importance (A-F): The Philadelphia Fed Index merits a B.
    * Source: The Philadelphia Federal Reserve bank.
    * Release Time: Third Thursday of the month for the current month.
    * Raw Data Available At: http://www.phil.frb.org

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The Philadelphia Fed's survey is first each month, actually coming out during the third week of the month for which it is reporting. Several smaller surveys are then released before the Chicago purchasing managers' report on the last day of each month.

These surveys can be of some help in forecasting the national National Association of Purchasing Managers data -- particularly the Philadelphia and Chicago surveys, which are more closely watched due to their timeliness and the fact that these regions represent a reasonable cross-section of national manufacturing activities.

Highlights

    * The Philly Fed's Business Outlook rocketed up to 14.1 in September from 4.2 in August. The consensus only expected a reading of 8.0. This was the highest reading since June 2007 and represented the second-consecutive positive reading.

    * Unfortunately, it is still too early to declare how the increase in production will play out in GDP growth. Inventory levels continued to shrink in July and economists have been anticipating a bump in production will ease the inventory contraction. The businesses surveyed by the Philly Fed contracted at a very strong pace over the last month and businesses will have to replenish their stocks soon.

    * New order activity growth slowed slightly in September as the diffusion index slipped from 4.2 in August to 3.3. However, shipments rose from 0.6 to 8.2 in September.

    * Profitability remains a problem as prices paid for inputs grew while prices received for the finished goods fell over the last month.

    * The labor market remains weak as the number of employees index declined from 12.9 to 14.3. However the contraction in the average workweek slowed from -6.3 to -3.9.

    * The future continues to look bright as 59.8% of businesses expect increased business activity six months from now.

    * Firms remain over invested in capital equipment and new investment is expected to be neutral in six months. As consumer demand expectations grow over as the economy recovers, we expect capital expenditures to grow as well.

Key Factors

    * The strong Business Outlook follows a similar reading from the New York Fed's Empire Manufacturing sector. The report is a clear signal that the manufacturing sector is beginning to come on-line and we should expect strong manufacturing production over the next few months.


THURSDAY, OCT. 16

9:15 a.m. Industrial Production

    * Importance (A-F): This release merits a B-.
    * Source: Federal Reserve.
    * Release Time: 9:15 a.m. Eastern around the 15th of the month (data for month prior).
    * Raw Data Available At: http://www.federalreserve.gov/releases/G17/Current/g17.txt

The index of Industrial Production is a fixed-weight measure of the physical output of the nation's factories, mines, and utilities. Manufacturing production, the largest component of the total, can be accurately predicted using total manufacturing hours worked from the employment report.

One of the bigger wildcards in this report is utility production, which can be quite volatile due to swings in the weather. Severe hot or cold spells can boost production as increased heating/cooling needs drive utility production up.

In addition to production, this monthly report also provides a measure of capacity utilization. Though the rate of capacity utilization is seen as a critical gauge of the slack available in the economy, the market does not completely trust this measure.

Highlights

    * Industrial production jumped 0.8% in August after the consensus expected a slightly softer increase of 0.6%.

    * As expected, the manufacturing sector continued to rebound as it increased production 0.6% after rising 1.4% in July.

    * Much of the bump in manufacturing production was due to an increase of 0.7% in the nondurable manufacturing sector. The increase was led by food, beverage, and tobacco production (1.6%) and chemical production (0.7%).

    * Slightly surprising, the increase in oil prices did not fuel an increase in petroleum and coal production, which declined 0.5%.

    * In the other industry groups, mining production rose 0.5% and utility production increased 1.9%. The surge in utility production was due to temperatures returning to a more normal August after a mild July. The warmer temperatures increased the need for air conditioning.

    * Capacity utilization also increased higher than the consensus expected (69.0%) to 69.6% in August.

    * Manufacturing capacity utilization increased to 66.6% from 66.1%. Mining capacity utilization increased to 82.2% from 81.7% and utility utilization rose to 78.7% from 77.3%.

    * Broken down between stage-of-process groups: the crude group capacity utilization increased to 80.7% from 80.0%, primary and semifinished group increased to 66.7% from 66.3%, and finished group rose to 67.7% from 68.5%.

    * Motor vehicle assemblies increased 12.1% to 6.57 million units. Auto assemblies increased 13.7% to 2.58 million units while light truck assemblies increased 10.8% to 3.99 million units.

    * Medium and heavy truck assemblies, which give us an idea about future demand in the shipping industry, grew 25% to 0.15 million units. Medium and heavy truck assemblies are still well below the average 2008 production rate of 0.22 million units.

Key Factors

    * The good news for the manufacturing sector was that the increase was not only due to a rebound in the auto sector. It's true the Cash for Clunkers rebate helped fuel demand for autos and the lower inventory levels provided an incentive for auto manufacturers to increase production by 11.7%, but outside of the motor vehicle sector, manufacturing production still rose a healthy 0.4%.

    * Yesterday's strong Empire Manufacturing report coupled with the expected strengthening in next week's Philadelphia Fed Manufacturing Index give us strong inclination that the manufacturing rebound is not going to disappear after only a few months.

      Capacity utilization is still extremely low and signals that expected consumer demand remains well below normal levels. As expected demand grows, production will boost capacity utilization, but do not expect normal utilization levels of about 80% until late 2010.

Big Picture

    * Production held up surprisingly well through most of 2008 due in part to strong exports.  Exports grew at a 7.0% annual rate in 2005, 9.1% in 2006, 8.4% in 2007, and at an annual average rate of 7.8% through the first three quarters of 2008.  Then, the bottom fell out in the fourth quarter as the financial crisis spilled over to the real economy at home and abroad, severly impacting global trade and end demand that led to declining levels of industrial production and capacity utilization.  The near-term trend is expected to improve as financial markets, and global economies, have stabilized.


9:55 a.m. University of Michigan Consumer Sentiment Index

    * Importance (A-F): This release merits a B-.
    * Source: The University of Michigan.
    * Release Time: Preliminary: 10 a.m. Eastern on the second Friday of the month (data for current month); Final: 10 a.m. Eastern on the fourth Friday of the month (data for current month).

The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading. Like the Conference Board index, it has two subindexes - expectations and current conditions. The expectations index is a component of the Conference Board's Leading Indicators index.

Highlights

    * The University of Michigan Consumer Sentiment index rose in September to its highest level since January 2008.

    * September's final reading of the index increased to 73.5 following the preliminary reading of 70.2. The consensus expected a much more modest increase to 70.5.

    * The current economic conditions and future economic outlook indices were almost the same.

    * Current conditions sentiment rose to 73.4 from a preliminary reading of 71.8. The final reading for August was a much more modest 66.6.

    * Future sentiment increased to 73.5 from a preliminary reading 69.2. The reading is up 8.5 points from its reading at the end of August.

    * The consumer put less pressure on the Fed by lowering their inflation expectations for the third consecutive month. The 1-year ahead expectation declined from 2.6% in the preliminary to 2.2% in the final. The 5-year ahead expectation declined from 2.9% in the preliminary to 2.8% in the final.

Key Factors

    * The strong sentiment numbers should not come as much surprise. The index is highly correlated with income, unemployment, gas prices, and news reports. All four components strengthened substantially throughout the month.

    * Please note, the increase in consumer sentiment does not necessarily translate into increased consumption spending. The main drivers for consumption are current/expected income and available credit. The consumer still faces difficult constraints in both sectors which will make consumption growth more difficult.

Big Picture

    * Sentiment readings are a reflection of a variety of events rather than an accurate tool for forecasting consumer spending.  Gas prices and political events can have an outsized impact on sentiment.  In general, these data are of very little economic value.

Source: Briefing.com