Dear SlingShot Trader Subscriber,
Whenever we see stock prices dropping, the question that runs through all of our minds is this: “Are we seeing a short-term pullback, or are we seeing the beginning of a new bearish trend?”
This is an incredibly difficult question to answer. In fact, it’s virtually impossible to answer at the beginning of a turnaround. The best we can do is watch and see how the turnaround plays out over time.
However, there are some clues we can watch for along the way that can help point us in the right direction. Some of those clues revolve around the idea of a “flight to safety.”
When investors become increasingly nervous about the potential losses they may be exposed to by investing in riskier assets, such as small-cap stocks, emerging-market equities and leveraged currency trades, they tend to move their money from those areas to safer assets, such as U.S. Treasuries and defensive stocks. At the same time, they tend to buy protection for the riskier parts of their portfolios, which shows up in indicators like the CBOE Volatility Index (VIX).
By monitoring these asset classes, we can get a better idea of whether we are seeing a short-term pullback or a new bearish trend. We’ll take a look at some of those clues now, but to try to keep things in perspective, we are going to look at weekly charts.
Small-cap stocks, as measured by the Russell 2000 (RUT), have been losing ground during the past few weeks.
Weekly Chart of the Russell 2000 (RUT)
However, as you look at the longer-term trend of the weekly chart, small-cap stocks still have a long way to go before the recent action constitutes a significant bearish move, or even a break of the prevailing trends.
Emerging Market Equities
Emerging market equities, as measured by the iShares MSCI Emerging Markets Index Fund (EEM), have fluctuated back and forth in the same range for the past three years.
Weekly Chart of the iShares MSCI Emerging Markets Index Fund (EEM)
So, while the recent pullback has been concerning, emerging markets stocks are still above a key support level. Until they break through the level shown in the chart above, it is too early to write them off.
Leveraged Currency Trades
One key currency trade that analysts have been watching is the carry trade with the Japanese yen (JPY). This trade involves selling the JPY short and using the proceeds to buy assets — like U.S. equities — denominated in other currencies. This trade weakens the value of the JPY.
As you can see in the weekly chart below of the U.S. dollar versus Japanese yen (USD/JPY), the USD has been getting stronger compared to the JPY for the past couple years thanks to the quantitative easing (QE) program of the Bank of Japan (BOJ) and the carry trade.
Weekly Chart of the U.S. Dollar versus the Japanese Yen (USD/JPY)
In recent weeks, however, the carry trade has started to unwind a bit, which is concerning for U.S. equity investors. But when you look at the weekly chart, you can see that the longer-term trend is still intact. This tells us it is still too early to worry about the imminent demise of the carry trade.
The price action in U.S. Treasuries continues to be difficult to interpret. On one hand, traders have been selling Treasuries to get out in front of the Federal Reserve as it tapers its QE program. This has been pushing Treasury prices lower and Treasury yields higher. On the other hand, traders have been buying Treasuries as a “safe-haven” investment. This has been pushing Treasury prices higher and Treasury yields lower.
Lately, it looks like the flight to safety has been the dominant force in the Treasury market, as you can see in the chart of the 10-Year U.S. Treasury Yield (TNX) below.
Weekly Chart of the 10-Year U.S. Treasury Yield (TNX)
However, as yields near support, we could see a bounce in the near term — suggesting an increase in confidence in the market.
Defensive stocks, like those in utilities, military defense contractors and consumer staples, tend to outperform riskier stocks, such as those in the technology, financial and consumer discretionary sectors, during market pullbacks.
One great way to monitor whether defensive stocks are in control or not is to look at a relative strength chart comparing the Consumer Discretionary Select Sector SPDR Fund (XLY) and the Consumer Staples Select Sector SPDR Fund (XLP). When the chart is moving higher, discretionary stocks are in control. When the chart is moving lower, defensive stocks are in control.
Weekly Comparison Chart of the Consumer Discretionary Select Sector SPDR Fund (XLY) and the Consumer Staples Select Sector SPDR Fund (XLP)
As you can see in the weekly comparison chart above, defensive stocks have had a good couple of weeks, but the longer-term uptrend illustrating firm control by discretionary stocks has yet to be broken.
CBOE Volatility Index (VIX)
Lastly, while the CBOE Volatility Index (VIX) has been rising, showing increased investor concern, it hasn’t risen all that much from a historical perspective.
Weekly Chart of the CBOE Volatility Index (VIX)
Each time the VIX climbed toward 23 during the past year, the market quickly turned around, sending the VIX back down below 15. Until we see the VIX approach 28 or even 45 — like it did in 2011 during the first debt-ceiling debacle — it is too soon to say the market is panicking.
The Bottom Line for Next Week
While stocks have been falling and certainly have more room to fall in the near term, the potential for a bullish bounce — no matter how short-lived — is still quite real. Tomorrow’s monetary policy statements from the European Central Bank (ECB) and Bank of England (BOE), combined with Friday’s official employment announcement from the Bureau of Labor Statistics (BLS), will go a long way toward determining whether this is just a short-term pullback or the beginning of a new bearish trend.
This Week’s Events
Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.
Feb. 6 — European Central Bank (ECB) Monetary Policy Statement
Feb. 6 — Bank of England (BOE) Monetary Policy Statement
Feb. 6 — U.S. Trade Balance
Feb. 7 — U.S. Employment Data
Feb. 11 — Chinese Trade Balance
Feb. 11 — Chairwoman Yellen Testifies Before House Financial Services Committee
Feb. 12 — Cisco Systems (CSCO) Earnings Announcement, after the market closes
When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here. You can also see more trade-specific details by clicking on the trade links below.
These are the SlingShot Trader positions that are currently open and active.
Bank of America (BAC) — On Feb. 4, we recommended you “buy to open” the BAC March 16 Puts for $0.48 or less. If you can still get into it at a price below our recommended maximum, we still like the trade.
Cisco Systems (CSCO) — On Jan. 31, we recommended you “buy to open” the CSCO March 21 Puts for $0.55 or less. If you can still get into it at a price below our recommended maximum, we still like the trade.
RadioShack (RSH) — On Feb. 3, we recommended you “buy to open” the RSH March 2.50 Puts for $0.50 or less. If you can still get into it at a price below our recommended maximum, we still like the trade.
CurrencyShares Japanese Yen Trust (FXY) — On Jan. 28, we recommended you “buy to open” the FXY March 97 Calls for $0.80 or less. If you can still get into it at a price below our recommended maximum, we still like the trade.
Honeywell International (HON) — On Jan. 22, we recommended you “buy to open” the HON March 90 Calls for $2.75 or less. If you haven’t already entered this trade, we recommend waiting for further updates before entering.
These are the SlingShot Trader positions we closed during the past week of trading.
Arch Coal Inc. (ACI) — On Feb. 4, we recommended you “sell to close” the ACI March 4 Put. We closed the position for $0.30 for a loss of 14.29%.
Newmont Mining (NEM) — On Jan. 31, we recommended you “sell to close” the NEM March 23 Puts. We closed the position for $2.22 for a gain of 94.74%.
Facebook (FB) — On Jan. 30, we recommended you “sell to close” the FB March 57.50 Calls. We closed the position for $5.60 for a gain of 24.44%.
Webinar Preview: Join Us Tonight at 8 p.m. ET
Every Wednesday at 8 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.
And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at firstname.lastname@example.org.
If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.
John Jagerson and Wade Hansen
Editors, SlingShot Trader