The One Crucial Thing the Market is Forgetting…
Just 10 months ago, good news was bad news for the stock market.
It seemed every positive housing or jobs report, manufacturing data point or consumer confidence number was enough to send investors running for the exits.
That’s because the strengthening economic picture increased the prospect of the Federal Reserve raising interest rates for the first time in nearly a decade. And investors feared a rate hike would choke off economic growth and hit corporate earnings.
Now, the market seems to have forgotten those fears altogether.
While strong economic data could still be a precursor to higher rates, it’s being seen as a positive for the market — driving stocks higher over the past month and causing some analysts to say negative sentiment has passed.
The market can’t have it both ways, though, and good news may again be bad news for stocks very soon.
Is Good News Bad or Good Now?
At the start of 2016, similar fears of sluggish economic growth and slowing earnings caused many investors to push the idea of rate hikes off the table. As the prospect of a global recession sparked by China threatened to end the seven-year bull market, U.S. stocks corrected more than 11% in just the first few weeks of the year.
But when February manufacturing data showed new signs of life, the mood seemed to shift dramatically. The Institute for Supply Management’s national factory index increased to 49.5 — the highest reading since September.
More good news came in the form of the latest jobs report. The economy added 242,000 jobs in February, well ahead of expectations of 190,000, and both the December and January numbers were revised higher.
These positive economic data points eased fears of a recession and helped the market recover some losses, yet they haven’t turned into fear of a rate hike — yet.
Julian Emanuel, executive director for U.S. equity and derivatives strategy at UBS (NYSE: UBS), told CNBC recently that better-than-expected U.S. economic data has popped the “negativity bubble” and could drive stocks even higher. But one former Fed president thinks the market may be underes-timating the likelihood of rate increases.
Charles Plosser, who led the Philadelphia Fed from 2006 to 2015, weighed in after the February jobs report was released. He said the Fed would probably not raise rates when it meets on March 16, but added that it may have to play catch-up in coming meetings due to strong economic data. He also suggested bigger hikes of perhaps 50 basis points instead of the expected 25 basis points could be possible.
The market is pricing in almost no chance of an interest rate increase in March, but the odds of a hike in June are increasing. The CME Group FedWatch put the chances of a 25-basis-point hike in June at just 12% last month. Those odds have since jumped to 36%, with a small probability of an even larger rate increase.
Some are worried that the current cycle of increasing rates could look a lot like the 1994 debacle when the Fed raised rates too quickly. Between February 1994 and February 1995, the Fed’s short-term rate increased 3 basis points. The market fell roughly 8% after the second rate hike and then went nowhere until early 1995. While I doubt the Fed will raise rates as quickly this time around, it’s likely to increase the benchmark rate faster than investors anticipate.
Economic growth in the Unites States and a better outlook abroad due to stronger energy and commodity prices should help push long-term rates higher in unison. Higher rates mean lower prices for bonds, and that is where today’s trade comes in.
Book a Double-Digit Profit as the Market’s Memory Returns
The iShares 20+ Year Treasury Bond (NYSE: TLT) tracks long-dated bond prices and, therefore, moves inversely with interest rates. In other words, as rates and rate fears increase, TLT should fall.
Currently trading at $ 129.19, I see the fund falling to at least $ 123, and possibly breaking even lower, as investors begin to worry about higher rates ahead of the June FOMC meeting.
My initial target is only 5% below the market price, but using a simple put option strategy, we can leverage that move into 33% gains.
Currently, we can buy a TLT Jun 128 Put for about $ 3.75 per share. This is a put option with a $ 128 strike price that expires on June 17. Each contract controls 100 shares, costing you $ 375.
The trade breaks even at $ 124.25 per share ($ 128 strike price minus $ 3.75 options premium), which is 4% below the current price.
If TLT hits my $ 123 target before the June expiration, the option will be worth at least $ 5 ($ 128 strike price minus $ 123 stock price) for a 33% return. Place a good ’til cancelled (GTC) order to exit at this price. Since we’d earn that profit in 100 days or less, the annualized return works out to a minimum 122%.
That may sound like a lot, but when it comes to options, the returns can be even more spectacular. For instance, last year my colleague Jared Levy recommended an option on TLT that delivered a 50% profit in just 15 days. That’s an incredible 1,205% annualized gain.
And that isn’t even his best return.
In the past year, Jared has closed seven trades with annualized gains of more than 2,000%, and even some that returned more than 3,000%. His strategy is just as simple as the one I shared with you today. If you’d like to learn more about it, follow this link.
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