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Record Option Speculation. Intensifying Downturn. Free Put Options.

“People don’t want cycles, they want narratives.”
Keith McCullough

“Simplistic economic narratives, especially comforting ones that entice those looking for shortcuts, often mislead much more than enlighten.
MOHAMED A. EL-ERIAN

“We have never had such a disconnect between the actual realities of the economics and how the market is performing. We have too may people out there who are gambling.”
Gordon Long

2023 began with even greater excitement about disinflation and lower interest rates than we saw in the last months of 2022. This can be measured by new all time call option volume, on the day after the February 1 Fed meeting shown below. Speculation has escalated. Options volume is dominating daily trading. 70% of daily volume on a daily basis is now options! 45% of S&P 500 options expire in 6.5 hours or less.

At the same time the Fed’s statement and strategy seemed broadly unchanged when you examine what Powell actually said.

Interest rate markets have since reverted to the Fed script but stocks remain near recent highs. For how long can economic trends and conditions which historically have reliably proved to be hostile to stocks be ignored?

Technology stocks rise, but violently diverge from earnings and sales declines.

The technology heavy exchange traded fund, QQQ, has so far reported an earnings decline of 15% for the Q4 2022 earnings period, and yet it is up around 16% year to date. Technology stocks even have a sales decline of around 4%.

Fundamentals Continue to Deteriorate Significantly

For all the excitement about a peak in US interest rates starting last October, the chart below shows that the market is now pricing in a new high in peak rates in the current cycle.

The data in 2023 has been very weak in growth terms. The best measure of this is the bond market’s interpretation. The yield curve has inverted to a new record level of 82 bp. This is a measure of how deep a recession the Treasury market is indicating. The chart below also shows that recession happens regularly around 18 months after it inverts. This time it inverted in July 2022 so we are on track for an end 2023 recession.

Even before the latest peak in rates, business credit conditions had already tightened to levels that have ALWAYS coincided with recession according to the latest Senior Loan Officer Opinion Survey on Bank Lending Practices.

Consumers are not far behind. Banks’ willingness to make consumer loans has fallen sharply; net % willing to do so has fallen into negative territory per latest Fed data.

Interest rates are rising deeper into the earnings decline than in prior recessions

“Looking at S&P 500 forward EPS peaks in 2000, 2007, and 2020, they all occurred when the Fed was either at terminal rate or already cutting rates … this time, peak in estimates occurred when Fed was still in early phase of rate-hiking cycle.”
Liz Ann Sonders

This means the Fed is tightening much deeper into the earnings declines than in the prior recessions. So earnings could fall more on this occasion.

“Morgan Stanley’s non-PMI leading earnings indicator does not bode well for EPS growth.” It projects an epic decline.

Historically stock markets move with earnings growth. Yet the earnings decline is far from over.

4.5% interest rates provide a safe haven and cheap put option financing

Given the complexity of current investment conditions and behavior it is worth taking advantage of higher short term interest rates for safe income. USFR for example provides 4.5% interest rates on Treasury credit.

10,000 produces around 450 of income over a year and possibly more over 2023 assuming the current structure of interest rates. So a single June put option on an ARKK 30 dollar strike, costs just 107, and could provide a 3000 short position if ARKK were to break the recent lows. An investor would still have over 300 left even if ARKK does not break down. In this sense the position provides income well in excess of what you would pay for the option. Heads you still have positive income. Tails you could have substantial gains in a declining market. There are many ways in which to generate income for option buying, with some low cost options. This is just an example of what you can do, not a direct recommendation.

Summary

These are challenging conditions for asset management, and these conditions have never been experienced before by most investors today. The combination of record debt, high inflation, and weak long term growth make policy making and investing unusually difficult.

Currently, to assume that a recession can be wished away and it is possible to just jump to the next growth cycle seems unrealistic. The rally may reflect the recent decline in financial tightening conditions and temporary liquidity factors, rather than any genuine prospect of a cyclical upturn.

Long term creative thinking is necessary as the fragility of the economic backdrop will require constant attention over the next few years. The video below can provide plenty of ideas.

Transform Your Investment Experience

The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs Best Investor metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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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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