Now That Did Not Take Long

Last week, we presented an analysis concerning rising interest rates and the probable change in global money flows. It is fundamentally clear that the prognosticators on Wall Street do not understand what is happening in the fixed income markets. A huge percentage of the investment professionals who work in the field of investments have joined the workforce since 2009. So all they know is an interest rate environment in which there has been massive market intervention resulting in interest rates that far lower than what would exist in a free market.

As an aside, the ECB has distorted the fixed income markets in Europe far beyond what the Fed did in the US. The governments of Spain and Italy borrow money at rates lower the US Government. Yet, these governments have no hope of repaying their debts. Once rates normalize, we think they will have great difficulty just paying interest. (If the US government does not get its act together, they may find themselves in the same boat. At the moment, the US has a fighting chance as the economy is growing quite rapidly, which will increase revenues to the US government with which to services their debts.) The distortions caused by the zero interest rate policy has led to zombie companies. These are companies that could be viable if they undertook the painful restructuring that companies need to do to compete in an ever-evolving global economic marketplace. Putting that off for another day only weakens the economy in the long run.

In the final analysis, the ECB is trapped. Either they continue to buy all the government debt issued, just like the Bank of Japan has done since 1980, or they will have to let rates return to a normal level, one they reflect market forces in a free market. When that day comes, bond prices will fall as they are doing here in the US.

The Fed is showing some wisdom and courage as they reduce their influence on the bond market. But that process is causing some pain. As interest rates rise and bond prices fall, investors are taking losses. As that occurs, the financial markets will de-lever and this will cause selling pressure in both the bond and equity markets.

At the same time, there is another phenomenon going on. Emerging markets are not doing well. As a result, we think money is flowing into the US from these geographies. We think that money is coming from Southern Europe, Asia, and South America. To find a home, it looks like that money is flowing into the biggest and bluest chip stocks in the US (i.e. primarily stocks in the Dow Jones Industrial Average and the S&P 500 secondarily).

The chart above of IWM, the ETF that tracks the Russell 2000, whose constituents are small-cap stocks with equity valuations of a few 100 million to a few billion.  These stocks tend to deliver goods and services to the US marketplace. Said another way, they are not multinationals and are less well known by foreign investors.

As you can see, this ETF has just broken the uptrend line that has been in place since Q1 2016. This is an ominous sign as it is the first signal that a correction of some significance could be ahead of us. It certainly appears that higher interest rates are hitting the price of small cap stocks.

The same cannot be said for the Dow Jones Industrial Average. As you can see from the chart above, INDU is still in the middle of its bullish trend channel. It needs to fall about 1,000 points before it breaks lower support line. The same phenomenon is true of the S&P500

If we were back on a prop trading desk or working at a hedge fund, we would buy DIA and/or SPY and sell IWM as we expect small stocks to under-perform mega-cap stocks. Most investors are net long stocks and they hold stocks across the market cap spectrum. As a result, those investors might want to take a look at doing some hedging.

When bullish, we like to buy the strongest index. When hedging or speculating on a bearish move, we like to sell the weakest index. As a result, we think one should focus on IWM. We will discuss two structures today, one for those looking for a slow selloff and one for those looking for something bigger.

For those looking for just a minor controlled selloff as the markets adjust to higher rates, consider selling an at or slightly in the money call spread. With IWM trading $162.14, consider the following trades.

To initiate a short call spread, the investor collects $234 up front which they get to keep so long as the share price trades below $162 at the November expiration date. The investors who use this structure is looking for the price of IWM to stagnate for fall. There is a 60% chance of making money on this trade and the breakeven level is a little over $2 higher than the current price, giving a little room for error.

The second structure is a long put speed. To initiate the trade, one pays $153 up front. If the trade works as planned and the price of IWM trades at $157 or lower, the investor will make $347, which is a 224% return. There is more to be gained with this trade, so the probability of profits is lower at 43%. At the same time, the amount one can lose is less as well.

When deciding what trade might be right for you, consider your risk tolerance and the degree of conviction you might have with the possibility of IWM moving lower. If the DJIA and SP500 turn down than IWM is likely to sell off sharply. If however the DJIA and SP500 continue to struggle but stay up, then we expect IWM to be weak but not collapse.

With IWM trading up about 3/4thof a point at 10:45 ($162.60), then you might want to move the strikes up $0.50 to $1.00.

Image Source | Lorenzo Cafaro,