Economic Outlook Trading Tactics

Current Market Conditions and how to Trade Simple Options. Part 1/3

Preface

I was thinking a lot about this what I am going to lay out here. I have done it in  the past but also differently. What am I talking about?

The question is how to continue trading with the feel that the market will have a huge pullback coming up. 

  1. Last week and this week the markets dropped twice by 5% the NASDAQ (QQQ) and 3.5% the S&P500 (SPY).
  2. We have longer than expected inflation and it will stay at raised levels.
  3. We have a slowing economy and employment numbers.
  4. The Delta variant is threatening to close the economy again
  5. Israel might attack Iran for building the nuclear bomb
  6. China might attack Taiwan
  7. Consumer confidence is lower than at the out break of the pandemic.
  8. Labor shortage and 10 million open jobs
  9. The Feds are buying bonds to keep the yields low like never before.
  10. The Feds are buying Mortgage backed securities like never before.
  11. Home prices soaring to new highs
  12. Banks are sitting on too much money and have to lend it out.
  13. The US economy is financed by debt like never before.
  14. Chinese debt and housing bubble and/ or crisis. Chinas Energy Crisis.

What will be the impact.

  1. Number 1 can be a sign that institutions are starting to roll over their positions or staying out of the market. Uncertainty.
  2. Higher inflation go hand in hand with higher asset prices, the stock market.
    Many borrow money to invest into the stock market until it crashes.
  3. This item should lead to lower prices and hence less inflation but since the Feds are pumping money into the circulation commodities and asset prices  will inflate.
  4. If this item #4 will continue to be a bigger problem the Feds will continue to print money, driving stocks higher and so inflation for consumer and producer. This will then create STAGFLATION. Slowing economy but higher prices!!
  5. This #5 will have the same impact as 4. Crazy and uncertain times require the Feds to print money.
  6. The same as 5
  7. Shows stress at consumer level which was about 90% accurate in the past. The University of Michigan Consumer Sentiment Index.
  8. This is not a result of monetary policies what the Feds do, but this is result of fiscal policies what the Trump and now the Biden administration does. Paying people for staying home and deleting small businesses.
  9. Drives inflation and stock prices higher and higher. The total value of all traded companies on the New York Stock exchange is measured by the Wilshire 5000. It gets compared to the GDP as a ratio. This is the Buffet indicator. It is at 239% of the market cap. this means 91% above the historical exponential trendline. This is significant. The market as a whole is strongly overvalued. Something has to give.

  10. Buying mortgage backed securities has 3 major effects.
    It eases the lending requirements for residential and commercial real estate buyers. It shoves the risk to the Feds in bundled asset classes
    It also more and more increases the percentage of bad apples in these bundles since at a given point in time the banks will run out of good or better clients.
    Third but not least, When the Feds start to taper the banks will tighten their risks, hence increase their Prime rates to balance the risk. Mortgages will become more expensive and cool off the housing and construction market
  11. Here bankruptcies and default are in the forecast.
  12. Cash is a liability for banks. They must lend out, no matter what. They will load themselves up with increasing risks, which will come to the forefront as soon as tapering will start. It will have a massive impact. HELOCs, LOCs, Mortgages, etc.
  13. Companies with a high debt to equity ratio and a current ratio of under 1 might have difficulties paying their premiums and /or getting financing due to tightened lending rules, interest rate hikes and soaring inflation. Companies will default. Their market cap is part of the equation and when the institutional traders divert their capital out of the stock market into bonds the crash will be here. Thats why the Feds will keep buying MBS and bonds to keep the yield down and the banks happy.
  14. A financial crisis in China will effect the US but not much. Almost all lenders are not US banks. 
Thus, this is my brief take on the situation. Follow me on Twitter, watch all images on HedgingStocks.blogspot DOT com

Conclusion

  • With all this being said I firmly believe after talking to many and doing research, running Excel spread sheets and graphs, with the scenarios of Israel on Iran, China on Taiwan, Delta on the US, US on China /Korea War, a slowing economy —-> the money printing will continue and hence the market will go up.
  • With an increasing inflation and when everybody will see that it is NOT a transitory one but a permanent one, then, we run the risk of an continuing inflation.
    • Firstly due to shortages and bottle necks like sea ports.
    • Secondly due to increased commodity prices and manufacturer input costs.
    • Thirdly due to labor and wage increases, which is part of the COGS item.
    • Fourthly and most importantly, due to money printing, which results in slowing the M1V and MV2 velocity and at the same time increasing the money stock, M1 and M2. More money for the same amount of goods inflates money.
  • Increasing inflation will force the monetary policies of the Feds to take action and taper. Tapering will slow down the banking system, slow down the economy as a whole. Tapering will reduce bond prices due to lower demand (Feds not buying) and hence the yield rate will go up. Institutions will start to transfer money out of the stock market!
  • When the Feds will start hiking interest rates the process of draining the stock market will accelerate. 
  • Tech stocks, cyclical stocks and meme stocks will fall first. Defensives stocks and staples later. A crashing stock market will bring the necessary correction. I would not be surprised to see a 40% correction in the market, the average of the past corrections we had. I would think that we see a deep correction when the yield rate hits 2.2% because the time of cheap money is over and when commercial and industrial loans have reached pre-pandemic levels at 1,600 billion Dollars.

What’s next?

Under the same title I will set up the right kind of trade for a crashing market or a dipping market, or a not trending market. Options are the word. But this will be explained in the next article.


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