The Striking Price

Get Ready for the Next Rally

STEVEN M. SEARS
Friday, March 6, 2015

Several factors point to continued gains for stocks. Here’s how to play it with options.

Stocks were surprisingly strong in February, and sentiment was surprisingly bad.

The Standard & Poor's 500 index rose 5.5%. It was the strongest performance in three years for a February, and a stunning end to a difficult month with mixed trading. Eleven trading days were negative; eight were positive.

Many investors missed the rally. They did not buy cheap call options that would have boosted returns. Instead, many incorrectly bought defensive put options in anticipation that the stock market would tumble. This decision widened their performance gap with their benchmark indexes, and should force them to soon chase stocks if prices keep grinding higher, as some strategists now predict.

After all, the first quarter will soon end, and fund managers will have to redecorate their portfolios lest their clients ask why they were not invested in the quarter’s winnings stocks. This window-dressing routine could boost the market, as could another tail wind starting to blow.

EQUITY STRATEGISTS are increasingly telling clients that the Federal Reserve’s first interest-rate hike, expected in summer or fall, should not be feared. Many investors intuitively think rising rates will roil stocks and trigger asset allocations, but historical data suggest that the S&P 500 performs well into the first rate hike. In fact, the market’s performance is historically so strong that we once again urge investors to consider buying inexpensive call options to wager on a continuation of the stock rally. This is not a recommendation to overweight portfolios with speculative calls. This is a tactical trading recommendation with manageable risk.

Ari Wald, Oppenheimer’s chief technical strategist, studied how the market has behaved through each interest-rate cycle since 1955. On average, the S&P 500 rose 15% 52 weeks before the rate hike, 11% during the 26 weeks before the rate hike, and 7% 13 weeks before. After the first rate hike, he said, the S&P 500 averaged a gain of 2% during the next 13 weeks, 6% 26 weeks after, and 10% 52 weeks after. The market’s strength suggests that investors overestimate the impact that rising rates have on stocks, and underestimate how stocks benefit from a strengthening economy.

Investors can trade this historical data—the key risk, of course, is that the past proves perfidious—in two main ways. Buy calls on the S&P 500 Trust (ticker: SPY) that are close to the market’s price and that expire in January. The trade offers the basic upside ride for those who believe the trend will be your friend.

Investors also can consider calls on sectors that led the market higher in February. Last month, the discretionary sector rose 8.6%, technology rose 8.2%, materials rose 8%, and financials gained 7.4%.

Of all the sectors attracting inflows, technology seems to be dominating attention. A popular trade is buying blue-chip technology stocks that have strong balance sheets and healthy cash positions. Rather than cherry-picking stocks, consider buying the Select Sector SPDR-Technology (XLK) or even the Select Sector SPDR-Materials(XLB). Pick strike prices near the market, and January expirations. If the U.S. economy is growing, and foreign central banks are cutting rates to stimulate growth, technology and materials should advance.

The mixed sentiment now backdropping the equity market should ultimately support stocks if March trading confirms February’s gains.

If that happens, it will likely be a tactical signal to buy inexpensive SPY puts because equity inflows may peak and the market could temporarily run out of bullish tinder.

Reprinted by permission of Barron's Online, © 2015 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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