Sunday, July 1, 2007

HOTS Weekly Options Commentary

HOTS Weekly Options CommentarySocialTwist Tell-a-Friend
Peter Stolcers

Last week the market opened with a whimper. Monday morning prices followed through to Friday's decline. Throughout the day it touched the SPY 149 support level and it bounced. Tuesday the market added to the decline and it broke below that support level. Just when things looked like they might finally breakdown, a snap back rally on Wednesday saved the day. Prices started out unchanged and once the bears exhausted their selling, the bulls took charge and rallied the market throughout the day. By the close, the S&P 500 futures had posted a 20 point gain. Thursday, a weaker than expected GDP report included "hot" inflation data and the market somehow viewed that as positive. Before the Fed released its FOMC comments, the market was moving higher.

Their rhetoric changed slightly and a few new words were added. After the release the market gyrated back and forth while it tried to decode the secret message. Friday, the PCE index showed that prices increased .1%, last month leaving the one year rate at 1.9%. That is just under the Fed’s 2% target and the market liked the news. I'm amused at the inflationary analysis. These numbers exclude food and energy. This is analogous to my neighbor analyzing my putting, "… apart from speed and direction, it was a great putt.” Soon they will need to exclude additional items and the report could read like this, “… excluding food, gasoline, health insurance, college tuition, medicine and travel - inflation is contained.” Obviously, the Fed is still concerned about inflation even if it doesn't show up in the standard metrics. Consequently, I believe the best case scenario is that rates will remain unchanged the rest of the year. Foreign interest rates are on the rise and it's widely expected that China will be the next country to raise.

A few weeks ago I came to the conclusion that the market would fall into a choppy, sideways trading pattern. My analysis was based on two facts. Earnings had been released and interest rates will remain unchanged. Those are the two driving forces behind the market and they are both "knowns". The market is searching for something to sink its teeth into and in the end; all of the little knee-jerk reactions will be meaningless. I did not expect an increase in volatility. It seems that once an intraday direction has been established, the buyers or sellers (whichever the case may be) step aside.

In this week's chart you can see that the volatility has recently expanded. Prior to June, the market was trading in a nice tight pattern. Now, large intraday price swings are common. Wednesday really caught my attention. Tuesday the market had a large range and it opened near the high and closed near the low. Wednesday the exact opposite happened, however Wednesday's open was below Tuesday's close and by the end of the day Wednesdays close eclipsed Tuesday's open. This created a large green candlestick and this is known as an engulfing pattern. It is normally considered to be bullish. What makes this so unusual is that the engulfing pattern occurred a day after an extremely large range. Friday was another example of a reversal. After a higher open, prices weakened and the market sold off going into the close. The S&P 500 has a 20 point range. An increase in the daily range usually precedes a large move. If I had to assign probabilities I would give the market a two thirds chance of breaking out to the upside and a one third chance for a breakdown.

The macro conditions are still in place for the market to move higher. Earnings are solid, balance sheets are strong, employment is robust, valuations are in line, interest rates are relatively low and inflation is "in check". The bid to the market is very strong and the market will continue to adjust to the notion of higher interest rates.

Next week’s economic releases are highlighted by the Unemployment Report that comes out Friday. Over the past few months, the market has rallied after the number. "Full employment" and moderate wage increases are good for the economy. The unemployment estimates have been in line, diminishing the importance of the ADP employment index (Thursday release). The ISM manufacturing and services numbers are also unlikely to have a major market impact in a quiet holiday setting. On the earnings front, I don't see a single stock that would catch my attention.

Next week you can expect a quiet week of trading. I believe that the recent volatility will start to calm down.

Have a great holiday!

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