Welcome to the Tom and Jerry Markets
Anyone who’s watched Tom and Jerry cartoons knows that a friendly game of cat and mouse can be quite amusing. In real life, however, cat-and-mouse games can have serious consequences. Currently, the markets and the Fed are playing a dangerous version of this game.
Overall, I remain selectively bullish, especially on a sector-specific basis. But, as I noted in a Flash Alert to subscribers this past week, the market’s response to the Fed’s latest rate increase and Chairman Powell’s press conference were concerning, as they pushed the markets into a bout of option-related volatility.
Of course, central banks in the past weren’t perfect. Certainly, gamesmanship has always been part of their modus operandi. I can remember when Alan Greenspan would keep the market guessing as to the Fed’s next move. In those days, the Fed would ease the Fed Funds rate and not make an announcement confirming what the repo market was exhibiting in terms of rates. The net effect was leaving the market to discern whether the Fed had eased or not.
In those days, it was a given that the Fed operated in a secretive world which required “Fed Watchers” to read and interpret the entrails of the central bank’s obtuse remarks. There were no Fed press conferences. The markets seemed to work better in those days. In contrast, in today’s “open” dialogue and “clear” communications reality, it’s become painfully obvious that the Fed, unlike in the days of Greenspan, has lost all its mystique and thus its ability to act in a timely and effective manner. This is fertile ground for big option traders to create intraday volatility and noise.
Don’t Chase Your Tail; Trade What You See
From a trading standpoint, what matters most is the market’s reaction to the Fed’s actions and words, especially over time. And what we’re seeing, despite intraday price gyrations, especially in the bond market, is a slow and steady descent in longer-term yields.
Primarily, the U.S. Ten Year note yield is diverging from the Fed Funds rate. This type of trading pattern suggests bond traders are starting to factor in a recession instead of worrying about inflation eating into their returns. That’s a big behavioral change, which the Fed should pay attention to. Yet, if history is a guide, it’s not likely that the Fed will ease until there is obvious evidence of a recession. Moreover, the jobs number released on 5/5/23 has muddled the picture, again.
So, when the Fed eventually eases, they may be as far behind the curve as they were when they started raising rates in 2022. This may cause them to overshoot their target and drop rates to a lower level than needed. And yes; that would likely ignite inflation.
As a result, instead of playing cat-and-mouse, the Fed could end up chasing its tail.
Cat and Mouse 2.0. – Bonds and Mortgage Rates
The bond market continues to price in a slowing of the economy, while homebuyers continue to play a separate but nifty game of cat and mouse (2.0) as they try to time the mortgage market. Meanwhile, homebuilder stocks continue to move higher.
Of note; despite the stronger-than-expected jobs number, the U.S. Ten Year Note Yield (TNX) has remained below 3.5%, while mortgage rates again eased last week.
Note how closely mortgage rates and the homebuilder sector (SPHB) continue to follow the general trend of TNX. Specifically, note the rally in SPHB, which was spawned when the average mortgage rate topped out in late 2022 above 7%. The subsequent decline in mortgages has been a boon for homebuilders.
For an in-depth comprehensive outlook on the homebuilder sector click here.
The Consumer’s Tale
The markets are trying to tell the Fed that the economy is slowing, but the central bank isn’t listening. Aside from the bond market’s actions (described above), the stock market agrees. Take the action in two bellwether stocks, McDonald’s (MCD) and watch maker Fossil (FOSL).
MCD is trading near its recent highs as consumers are watching their expenses. The fast food chain recently beat both revenue and earnings expectations handily while forecasting double-digit growth in both for 2023 while being able to pass on higher prices to consumers.
On the other hand, Fossil, formerly a high flying watch, handbag, and related accessories manufacturer and retailer is now a penny stock. FOSL is also a conduit, via licensing agreements, for other brands of luxury goods such as Armani Exchange, Diesel, and DKNY. As a result, its fortunes are excellent indications of consumer spending patterns.
The price charts sum the situation up quite clearly. A review of the Accumulation/Distribution (ADI) and On Balance Volume (OBV) indicators for both tell a tale of positive money flows for MCD while capital continues to flee FOSL.
On the other hand, outside the mainstream noise, the action in the extremely out-of-favor real estate investment trusts (IYR) is encouraging due to the changing landscape in the sector, which I highlight in my latest Your Daily Five video.
In fact, I have just added three REIT plays to my portfolio. Get the details with a free trial to my service here.
NYAD Stays Alive. NDX Breaks Out.
The New York Stock Exchange Advance Decline line (NYAD) went mostly sideways last week, but thankfully avoided a total breakdown while hugging its 50-day moving average, closing well above its 200-day moving average. So we’re left with middling breadth, which is better than horrible breadth.
The S&P 500 (SPX) remained in what has become a familiar trading range, between 4100 and 4200, but is getting closer to what could be a major breakout if it can get above the 4200 area. On Balance Volume (OBV) and Accumulation Distribution (ADI) remain very constructive for SPX.
Even though it was a volatile week, the Nasdaq 100 Index (NDX) closed above 13,200, scoring a nifty breakout with OBV starting to turn up a bit more decisively. If NDX can stay above 13,200, the odds of a significant move higher are well above average.
Thus, when it’s all said and done, despite the volatility, money continues to move into technology stock.
VIX Makes New Lows
The CBOE Volatility Index (VIX) again remained below 20, a persistent sign that the bears are throwing in the towel. This remains bullish despite the intraday volatility in the options market.
When VIX rises, stocks tend to fall, as rising put volume is a sign that market makers are selling stock index futures in order to hedge their put sales to the public. A fall in VIX is bullish, as it means less put option buying, and it eventually leads to call buying, which causes market makers to hedge by buying stock index futures. This raises the odds of higher stock prices.
Liquidity Remains Stable Despite Rate Hike
The market’s liquidity is moving sideways as the Eurodollar Index (XED) remains below 94.75, but did not make a new low after the Fed’s rate hike. That’s a positive for now.
A move above 95 will be a bullish development. Usually, a stable or rising XED is very bullish for stocks. On the other hand, in the current environment it’s more of a sign that fear is rising and investors are raising cash.
To get the latest up-to-date information on options trading, check out Options Trading for Dummies, now in its 4th Edition—Get Your Copy Now! Now also available in Audible audiobook format!
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Joe Duarte
In The Money Options
Joe Duarte is a former money manager, an active trader, and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best-selling Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com and now in its third edition, plus The Everything Investing in Your 20s and 30s Book and six other trading books.
The Everything Investing in Your 20s and 30s Book is available at Amazon and Barnes and Noble. It has also been recommended as a Washington Post Color of Money Book of the Month.
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