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Asymmetric Options Trades. Inflation Noise. Bank Signal Deepens.

“If there is so much noise, it’s because different raters have completely different ideas.” 
Danny Kahneman

Get the intermediate-to-long-term Cycle right and your capital preservation will be alright. Until you learn that lesson in risk management, you can’t compound your hard-earned capital like the best players in The Game do.
Keith McCullough

Don’t get too distracted by this weeks inflation data. Most of it was noise and a short squeeze in US equities.

Over the last 2 months these Weekly Insights have been examining the key credit growth issues. If banks have weak performance it means they are having problems extending credit, their main source of income.

An important market signal is still showing a red flag. The ongoing underperformance of banks relative to the S&P 500 shown below. This continues to hit new lows on a bigger signal than in 2000 or 2008.

Here’s an asymmetric options trade to take advantage of the short squeeze in equities…

It is worth understanding the messages from price action, and very few relationships are more important than how well banks are performing relative to the overall market. A healthy market and economy can’t continue for long without access to ample credit. The Bank stocks have been underperforming for well over 3 years. Far longer than they did just before 2000 and 2008.

Certainly, there is not much good news from trends in small business earnings and sales shown below. Many companies have deteriorating credit for bank loans and these earnings and sales trends undermine durable equity performance.

Whack-a-Mole Inflation Readings

While headline year-on-year readings last week for CPI and PPI fell for the first time in a while, almost all of the fall was attributable to the recent fall in energy prices. Oil inventories have risen in the last month or so, but all of this can be accounted for by SPR oil releases, so it’s not clear that oil inventories have durably recovered.

Meanwhile, many major inflation components are still rising. Notably, food, services and the housing component, which still seems to have a long way to go.

Furthermore, the CPI tends to follow the PPI. The chart below shows a record divergence between the two as the CPI tries to catch up with the with the PPI.

Inflation may still subside somewhat into year end but with Fed Funds interest rates still 6% below the CPI it seems very premature to anticipate the end of rising rates – a message numerous Fed speakers reinforced this week. Certainly, the Treasury bond market was unconcerned by the inflation data. The two year Treasury yield hardly moved over the week and remains in a clear uptrend. Meanwhile, long term maturities experienced higher yields following the data.

An Asymmetric Options Trade

It may be that after the recent equity rally, this is a good place to protect your equity portfolio from another downtrend. If so, the rise in interest rates so far can help cover the cost of equity put options. It is possible to generate at least 2.5% per annum, from a very low risk bond portfolio using Floating Rate Notes and short dated Treasuries. This income can cover the premium cost of an extensive range of carefully timed and selected put options.

The result could therefore be a zero cost overall short position on the equity market, either for protection or as an outright trade. Even in the worst case you would just lose the options premium. If this is less than the income from your bond allocation there would be no portfolio loss. On the other hand, if the equity market falls you would keep the income and, in addition profit from capital gains on the put options. Heads you win, and tails you don’t lose. An asymmetric outcome.

Naturally, seek advice from a professional if you have any doubt about how to structure or execute these trades.

It is important for investors to realize that you are not powerless to take advantage of a bear market in equities or be able to hedge your portfolio very effectively at minimal or even no cost. This can be shaped to any level of risk and capital exposure through the selection of a portfolio of put options, and income from a low risk bond allocation.

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Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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