Making Money from Downside Out-Performance…

Just a quick update before we get to the meat of this week’s recommendation.

It seems we’ve had a string of excellent timing recently – indeed, on nearly all of our last six trades.  Perhaps it shouldn’t be any surprise, though.  After all, the charts give us our direction and trading them simply works!

That said, two of those trades are covered writes, and there’s still time to go before March options expiry – not to mention April’s – so we’re not counting our chickens yet.  But it’s always good to see things moving in the right direction.

Here’s the recap:

1.    Of the bunch, only the Greek National Bank preferred (NBG.PR.A) is currently underwater (if you want to call a little over half a percent ‘underwater’).  And considering the thing is paying us nearly 11% annually, we’re hardly worried.

And by the way, here’s a little global contrarian trivia for you: which country’s stock market is up the most since the market bottomed and pulled up from the February 8th lows?

That’s right… Ukraine.  But who’s that in second spot?  Look here:

None other than Greece – Europe’s worrywart basket case – whose performance YTD is nearly twice that of our own.

2.    The rest of our picks look strong, so we’re holding fast.  Recent action in the oil and iron ore markets has us feeling vindicated and confident about Calumet (CLMT) and Great Northern Iron (GNI) – up nearly 9% and 6% respectively, not including fat dividends.

GNI also just broke above long term resistance at $95.70.  See here:

3.    And finally, the zero premium trade on the SPYder and GLD calls is also looking healthy.  For no money down, $167 per pair traded is now on the table.

No money down, friends.  That smells nice.

Going Forward Cautiously

As to what the future brings, we have to admit to some trepidation regarding the following visual, which speaks to the current state of investor confidence.

The American Association of Individual Investors’ weekly poll of sentiment is showing John Q. Public mightily bullish.  So much so, in fact, that since the bull market bottom of last March, investors have only been less bearish twice, in consecutive weeks near the former top reached in January, 2010 (indicated in red).

The alarm bells are gently dinging because we never like seeing too many bulls on the bandwagon while markets are rising.  It makes us itchy.  And it leads us to believe that there’s downside awaiting.

That said, it could be that investor sentiment stands to get considerably more bullish before we see another pullback.  That is, markets could yet climb higher.  But we’re not prepared to jump out of our current positions on a hunch that an intermediate- or even short-term top has been reached.

In all likelihood…

Chances are that we will see a heart rending swoon in the days or weeks ahead that puts the fear of the Almighty back into the hearts of stock worshippers globally.  A sharp, gut-wrenching dive of even 12% or 15% from current levels wouldn’t surprise us.

So long as the retreat is sharp and the news media screams bloody murder, we’ll feel confident that the bull is alive.  If, on the other hand, we get some slow, piddling water torture of a slide into the 10% to 12% loss range, with no great concern on the part of the investing public, we’ll seriously reconsider our staunchly bullish posture.

In short, the future’s a moving target, folks.  And we’re watching closely.

This Week’s Trade

We’re looking at a complex recommendation this week, based a number of factors that we’ve outlined above, and a few more that we’ll get to now.

·       First, to recap, we see the potential for a general drop in market levels in the days and weeks ahead that we’d like to capitalize on.

·       Second, we’re not exactly sure when that drop is going to happen (if it does), and

·       Third, we’re not exactly sure which stock to short.

Does that mean we’re helpless?  Hopeless?  Hapless?

No way.

Here’s the plan:

The telecom sector has been the most miserable performing subset of the equities market in the last three years.  That includes the decline from the last, general market peak in the fall of 2007 through to last March, and the rise from the March bottom until now.  Here’s a graphic that depicts that dismal performance beautifully.

On the positive side of the ledger, it’s harder to place the best performing sector.  Technology?  Health Care?  Consumer Discretionaries?  Consumer Staples?  We’ve chosen the discretionaries for the simple reason that at this point in the cycle we see the greatest upside potential for that group.  As the economy gains traction and employment and confidence numbers improve, it’s this area that stands to profit most from spending.

With that in mind, here is the performance of one of the worst performing telecoms, Verizon Communications, Inc. (NYSE:VZ) pitted against the Consumer Discretionary SPDR ETF (NYSE:XLY).  The chart shows the last full year’s trade.

Our trade is a play on this continued outperformance.  Downside outperformance, that is.

Should the market fall, we assume that telecoms will fall faster and farther than XLY.  Therefore, we’re buying Verizon puts and selling XLY puts.  Both are currently selling for almost the same price, so the cost to initiate the trade is virtually nothing.

Any broad move lower in the markets in the next six weeks should bring the trade into profitability.  And if the market moves up?  Both sets of options will expire worthless.  You’ll be out your commission costs.

Charts of the Week recommends simultaneous purchase and sale of the Verizon April 28 Puts (buy) at $0.38, and XLY April 31 Puts at $0.40 (sell)

And take two bucks on us.

With kind regards,

Stanley Barnes, Senior Analyst