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Issue No. 17 – March 14, 2005 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
This issue describes a low risk trade that can return 100% profit. Less than 3 weeks are left in the Option Alerts free period with a 40% savings on enrollment.
1.1 General Motors Corporation
General Motors Corporation needs little introduction. The stock was shorted by purchasing the September 32.50 put option. For the fiscal year ended 12/31/04, revenues rose 4% to $193.45 billion. Net income from continuing operations rose 29% to $3.69 billion. GM has a low PE, a low price to sales and a low price to book. However the stock has declined 23% in the past 52 weeks. It was downgraded to a sell by Bank of America on February 28th. Prices hit new 52 week lows on January 21st ($35.85), February 28th ($35.01), March 4th ($34.77) and again this week on March 9th ($33.91). GM prices are shown in Figure 1A.
FIGURE 1A
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent trades made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser
1.2 Inflation and Interest Rates
Fears of inflation and higher interest rates were momentarily switched on and off this week as the price of oil fluctuated back and forth between $53 and $55. News of higher than expected oil supplies coupled with an oil price movement lower caused stocks to rise earlier in the week. This was accompanied by hopeful speculation that OPEC will not reduce output at its next meeting this coming week. At the end of the week, consumption demand forecasts by IEA were raised to 84.3 million barrels/day as compared with 82 million not too long ago when spare capacity was only 2 million barrels a day. Oil moved above $54 on Friday bringing on a sell off in stocks. The markets are likely to remain unstable for a while.
The oil news coupled with a near record trade deficit caused Treasuries to sell off, as well, with the 10-year note recording its largest weekly decline since last May sending its yield to 4.53%. The prospects of measured interest rate increases by the Fed are now viewed with alarm.
Earlier comments out of Japan regarding the possible diversification out of U.S. debt instruments and continued weakness in the dollar also contributed to the sell off in bonds. Movement away from the dollar would lower its value and require the Treasury Department to raise interest rates significantly at future bond auctions, thereby reducing the value of bonds currently held.
Three years ago the ratio of daily trading volume for Currencies, Treasuries and Stocks was approximately 30:7:1. Assuming that this ratio has not changed too drastically, if we focus only on stocks, we are looking at only 3% of the picture.
· Rising commodity prices (oil) or the dollar losing its value can cause inflation.
· Inflation forces the Fed to raise interest rates.
· Increased interest rates require the Treasury to issue new bonds that yield a higher rate.
· Higher interest rates cause previously issued bond prices to decline (Why hold a low yielding bond when you can own a newly issued one that yields a higher rate?).
· Higher interest rates make newly issued bonds look more favorable compared to stocks, pulling funds out of stocks.
· Higher interest rates make it more expensive for companies to borrow, eating into earnings, and causing stock prices to decline.
· Sustained higher interest rates attract foreign capital, eventually increasing the value of the US dollar and lowering the price of commodities.
· Sustained higher interest rates slow the economy, reducing demand for energy and commodities, further lowering their prices.
The high performance of energy and materials stocks over the past few months has been due to the view that economy is firing on all cylinders. However, the perceived prospect of inflation followed by higher interest rates functions to foul the plugs causing stock market misfires.
The chart in Figure 1B shows a 2 year comparison of the CRB Index, the black trace, and the 10 year Treasury yield, the gold trace. The CRB Index is effectively a measure of inflation. Treasury rates have spiked sharply (up to 4.87%) within the past 2 years due to fears of inflation and settled back when those fears were seen to be unfounded. It is only within the last month and a half that increases in Treasury rates are correlated with a sharp rise in commodity prices. Notice the current RSI reading for the CRB Index. This time the interest rate increase is justified and is more likely to be sustained.
Copyright 2005 BigCharts.com
FIGURE 1B
To limit inflation, the Federal Reserve will continue to raise short term interest rates until the economy slows. Since the market is forward looking, a slowing economy will occur some time after negative market effects have been well under way. Measured rate increases of 0.25% in each of the seven remaining FOMC meetings in 2005 are expected to increase the short term rate to 4.25% by December. With a normal yield curve, rates for the 10 year note will be about 6%. This situation presents a unique trading opportunity that allows us to avoid the choppiness of stocks in the near term while the stock market sorts itself out.
1.3 Trading Opportunity
Traders can take advantage of the rise in interest rates by buying call options for the 10 year Treasury note yield on the Chicago Board of Options Exchange. The 10 year Treasury note interest rate is represented by a tradable index with the symbol TNX. Options for this instrument are European style. But they are traded like any other option before expiration. The option alert below recommends buying the December $45.00 call option with the symbol TNX LI. The $45.00 strike price corresponds to an interest rate of 4.5%. The Friday CBOE TREAS YLD 10 YR NOTES IDX closing price was $45.35, representing a yield of 4.535%. Each dollar of index value corresponds to 10 basis points or 0.10%.
Interest rates are admittedly difficult to predict. If the rate on the 10 year note rises by 0.5%, the option will be well in the money. This can occur after the next two FOMC meetings on March 22nd and May 3rd with measured rate increases of 0.25% each. Rates on the 10 year note rose this past week alone by more than 0.2% and over the past month by 0.5%. The short term overnight rate is currently 2.5%. If this rate reaches 4.25% in any of the next 7 FOMC meetings in 2005, the 10 year rate should reach 6% and the trade would net a 100% profit. The trade should be closed by mid November because the time value of the premium decays exponentially in the final 30 days before expiration. Otherwise, it is a low risk trade.
Wiser Trader Option Alert No. 9 – 3/14/05
Instrument: CBOE TREAS YLD 10 YR NOTES IDX
Symbol: TNX
Closing Price: $45.35
Option: DEC $45.00 CALL
Option symbol: TNX LI
Option closing price: $6.20
Option bid price: $6.00
Option ask price: $6.40
Theoretical fair value: $3.67
Suggested maximum entry price: $6.70
Suggested conditions for trade: None
Maximum Trade Duration: Up
to 34 weeks
Suggested Money Management: Use no more than 15% of risk capital
Suggested Trailing Stop: -25%
2.0 Market Analysis
Industry leadership in Table 1 below continues to take a short term view. Leading industries are ranked from highest to lowest. The tendency for gold to advance in all the major trading currencies is an indicator of global inflation.
Table 1