The market has continued to show robust signs of life over the last week, including a big push to the upside on Monday and a great open on Tuesday. Are we back to a bull market?
We have noted previously that, while big moves to the upside are better than some of the alternatives, we really want to see a calm market before getting too excited.
Bull markets tend to move slowly. The average price range in a bull market will fall week after week. It seems counterintuitive, but fast markets are most often associated with bearish crashes and bull traps — brief rallies followed by a crash.
So, we want to be careful and look at all the evidence before taking on too much risk.
Watch the Bond Market
One of the challenges we have right now is limited information from the bond market. We were stuck in a similar situation from 2009 to 2012.
The Federal Reserve was using a heavy hand to push the bond market around and drive interest rates lower. If the distributed influence of many traders isn’t the dominant factor in the bond market, we can’t really tell whether investors are becoming more confident or whether the Fed is just on a buying spree on a given day.
For example, you may have recently seen daily headlines that run something like this: “Stocks Rise while Bonds Fall,” which would normally be a good thing.
The problem is that the Fed has pushed rates so low that a 10-basis point move — a basis point is one-one hundredth of a percentage point — on the 10-year Treasury bond yield represents a 14% change. That sounds large, but a change of the same magnitude would have barely been a blip for bond traders last year.
As you can see in the chart of the CBOE 10-Year Treasury Note Yield Index (TNX) below, bond yields had been warning of a fragile market last year — something we pointed out several times — as they were falling.
Daily Chart of the TNX and the S&P 500 (SPX)
Yes, the decline has ended, but yield levels are still low enough that we can’t really consider this as “confirmation” of the rally as implied by the major indexes.
Investors Should Embrace Flexibility
Fortunately, option traders can be flexible about adding risk to their portfolio. With us, it’s not all-in or all-out as we wait on a bull market to return.
For example, we have made some modifications to our current strategy this week by buying back some of the short calls we sold for a tidy profit and leaving three more of our long-stock positions “uncovered” so we don’t get called out.
Our tentative plan at this point is to sell more calls once we start to detect more resistance in the market.
We have also added a little risk in the form of short puts on Extra Space Storage (NYSE:EXR). The storage unit business benefits from the four Ds (divorce, downsizing, death, dislocation), which are likely to be ongoing issues for the U.S. economy through the summer and fall.
Additionally, dividend yields from real estate investment trusts (REITs) like EXR are attractive when interest rates are low — despite what the headlines might otherwise suggest.
So, although a short put is a bullish trade, we are focused on a stock that should remain very defensive if the market gets choppy again.
What the Covid-19 News Means
As we wrote in March, the market is likely to turn the corner before the economy does, once we know more about the trends of viral infections, hospitalizations and deaths.
The good news this week has included reports that hospitalization rates in New York and New Jersey are leveling off, though deaths sadly, have spiked to new records.
Now, we are worried about when the hospitalization trends in Latin America, the U.S. Midwest and much of India will start to peak. We don’t know enough to be able to make solid estimates yet, so we have a cautious outlook.
As we pointed out last week, the sector rotation in the market makes this look like a normal economic cycle. Safe-haven sectors have lost less and gained more while basic materials, financials, industrials and retail dropped the most. We want to see those sectors switch places when the market rallies if a bull market is coming.
From a technical perspective, we would expect these positive changes to be signaled by a break above resistance among risky small-cap stocks. As you can see in the following chart, the Russell 2000 small-cap index is near a breakout point already.
Daily Chart of the Russell 2000 Index
A confirmed move above 1,180 would add weight to the argument that investors have found a bottom and are ready to start buying consistently.
The Bottom Line on the Bull Market’s Return
The news about trends in Covid-19 hospitalizations and deaths will drive the market. That will likely be the case for the next several weeks. However, this is also the start of first-quarter earnings season. The banks will start reporting in the middle of next week.
No one expects big surprises, but the outlook could help change sentiment for the better. Consider, for example, the big boost Nike (NYSE:NKE) got from its positive outlook on March 24. Earnings season could turn against us again if more companies choose the route taken by FedEx (NYSE:FDX) last month and wind up suspending their guidance.
For now, we recommend selling option premium when prices rally and leaving long-stock positions uncovered when momentum is positive. We think volatility will remain high enough to justify rolling out our short calls again in the short term.
This is probably not the point where we enter a new long-term bull market, but a price channel or consolidation — a tight trading range after a decline — looks more likely, which good for option sellers.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.