The Volatility Trader
105 W. Monument Street
Baltimore, MD 21201
Friday, October 13, 2006
Email – #201
Dear Volatility Trader Member,
I was standing in line at Starbucks this morning when my phone rang. It was Standard & Poors Index Services press contact. She was returning my message from Thursday night.
As I waited for my coffee, she told me the one number that’s so important to this market right now.
18.1
That’s the current P/E ratio of the S&P 500.
So if you’ve heard anyone breathlessly ramble that “this market is unstoppable right now,” this is exactly the time when you need to pay attention. That’s because this is the time when things can shift very quickly.
For example, let me tell you about the S&P 500 “max out” P/E ratio…
Are We Maxed Out?
The number derived is basically the level to which the S&P 500 can rally before being classified as “overvalued.” It’s calculated by dividing 100 by the 10-year Treasury yield.
In the past, the S&P 500 has traded over the “max” PE… but it’s always corrected, and moved back below.
Here’s the thing though: For the “max” P/E to increase, the 10-Year Treasury has to decline. This will happen if the Federal Reserve cuts rates next spring. That’s because easing the money supply allows companies to borrow more money… and subsequently injects more cash into the economy.
But right now, the “max out” P/E is 20.80, and the current P/E of the S&P 500 is near at 18. So from current levels, interest rates need to decline for “fair value” earnings to increase. And, at present, “fair value” earnings almost completely priced in.
The kicker is that the 10-year Treasury yield has rallied over the past two weeks, bringing the “max out” P/E down. And right now, the 10-year looks like it could continue higher after recently breaking above the 3-month descending resistance line. If the 10-year Treasury yield moves above 4.85% on Monday, you can rest assured that the near-term top is in.
Yellow Metal Approaching Resistance At $600
If you’ve followed the gold market over the past few days, you’ll see that the yellow metal has enjoyed a brief rally (shown on the chart below). However, it still faces significant risk of failing at $600. If it’s able to trade above $600, this will add more pressure to the major indices.
On a related note, I was chatting with Volatility Trader editor Martin Denholm last night, and an interesting point came up in conversation regarding the market’s next move – namely, the upcoming mid-term elections.
We believe there’s a good chance that at least one chamber of Congress will transfer from Republicans to Democrats. Now I’m not biased here, but I’ve read quite a bit lately about Democrats’ willingness to crack down on the Bush Administration’s spending habits, and potentially increase taxes.
Oddly enough, these crucial elections don’t really seem to be priced into the market at the moment. This goes against the market’s historical trend during the mid-term election cycle. Simply put, I think we’re close to topping out now – and it’s very possible that downside momentum could accelerate as we near election time in November.
Short-Term Reversal On Tap For Oil
Finally, let’s turn to the oil market. As the chart below shows, prices are trading near the descending resistance line, so if crude moves above $60 per barrel on Monday, expect a short-term reversal, and a significant short-squeeze in crude over the next two weeks.
Portfolio Update
Let’s wrap things up for the week with a quick look at the Volatility Trader portfolio…
Morgan Stanley
We’re currently holding the Morgan Stanley November 2006 $75 puts (MS-WO). I’m raising the stop to a close above $77. I think the entire sector is about to head south, meaning these puts will increase in value very quickly as the stock drops.
The stock failed to make any gains today, and with the 10-year Treasury yield climbing over the past two weeks, brokerages and banks are close to a hiccup.
American Eagle Outfitters
The underlying stock has rallied to the top end of the range, but has failed to close above our stop at $46.50. Last week, the stock traded up to that level, too, but failed to hold onto its gains. Given that the S&P 500 Retail Index (RLX) looks like it has already topped out, we’re seeking a quick reversal before expiration next Thursday. Hang tight – I’ll keep you posted.
TXU Corp
The stock is still reacting well, sit tight for now.
Goldcorp
The November 2007 $20 call (GG-KD) is up 25% from our entry. Keep the position open, as we’re looking for a little more upside next week.
Exit is everything,
Mark Whistler
Current Portfolio:
Stock or Option: Morgan Stanley Nov 2006 $75 puts (MS-WO)
Current Price: $1.30
Action to Take: Hold puts. Sell if MS closes above $77.
Stock or Option: Gold Corp Nov 2007 $20 call (GG-KD)
Current Price: $3.20
Action to Take: Hold Calls. Sell if GG closes below $20.
Stock or Option: American Eagle Outfitters Oct 2006 $45 puts (AQU-VI)
Current Price: $0.30
Action to Take: Hold puts. Sell if AEOS closes above $46.50.
Stock or Option: TXU Corp (NYSE:TXU)
Current Price: $61.74
Action to Take: Hold SHORT. Buy stop is above $67.50.
Stock or Option: TXU Corp Jan 2007 $55 puts (TXF-MK)
Current Price: $1.25
Action to Take: Hold puts. Sell puts if TXU closes above $67.50.
