Are There “Leaks” In The Stock Market’s Half Full Glass?

Other than a wild last 20 minutes this past Friday, S&P futures have been relatively calm the past few weeks, especially when compared to the volatility we saw towards the end of 2008 and the first part of this year. This is quite evident when looking at a chart of the S&P volatility index, or VIX, which has hovered just above and below the 30 level recently, near 9-month lows. Signs that the worst of the economic crisis are now behind us and a better than expected earnings season have been responsible for the approximately 38% rally in the S&P 500 since its lows were made back on March 9th. Economic reports have sent a mixed message regarding hope for an economic recovery, but yesterday’s reports were definitely viewed as positive for the economy, as weekly jobless claims fell by 4,000 to 621,000 last week. The bigger news, however, was the decline in continuing claims, which was the first decline in 17 weeks.

Also supportive was the surprisingly large gain in business productivity, rising a revised 1.6% annual rate in the first quarter. This improved productivity helped corporate profits rise by 3.4% in the first quarter. However, this gain came at the cost of lower employment, with companies cutting jobs and extracting more out of remaining workers. This now sets the stage for this morning’s release of non-farm payroll figures for May, with current estimates looking for a decline of about 520,000 jobs last month, with the unemployment rate expected to jump to 9.2%, which if true, would be the highest unemployment rate in nearly 25 years! Though the stock market seems to be in a positive mood, there may be some storm clouds on the horizon, as Treasury yields have soared, despite purchases from the Fed.

Debt investors are becoming nervous about the massive amount of debt the U.S. is running up, with stimulus packages and bailouts expected to propel the debt to GDP ratio to levels not seen since just after World War II. At some point, all this debt will force rates higher, as borrowers will want to receive higher compensation to absorb all this debt, which will, in turn, drive the cost of borrowing higher for other entities such as corporations, home buyers and state and local municipal bodies. These higher costs can slow down any economic recovery which would have defeated the whole purpose of the government ’stimulus “in the first place! If so, the rampant gains in the stock indices we have seen lately could come to an abrupt end.

Trading Ideas

Given the nearly 40% rise and relatively low volatility levels, traders expecting either a major correction or a continuation of the uptrend in the S&P futures may possibly wish to investigate the purchase of E-mini strangles in anticipation of volatility increasing or a big move in the futures. With the June contract expiring in less than two weeks, traders may wish to look at options against the September futures for trading ideas. An example of a long strangle trade would be buying the July 960 call and buying the July 900 put. With the Sept. E-mini S&P trading at 931.50, this strangle could be bought for 45.50 points, or $2275 per strangle, plus commissions. This debit is the maximum loss on the trade, and the trade is profitable if the September futures are trading above 1005.50 or below 854.50 at expiration in July. However, many traders would close out the position before expiration if the futures make a big move or if volatility increases sharply to help minimize the effects of time decay on the position.

Technicals

Looking at the daily chart for the June E-mini S&P futures, we notice prices trying to hold just above the recent consolidation around the 930.00 area. This is also just above the 200-day moving average, which is viewed by many technical traders as the determinant as to whether a market is bullish or bearish. Though bulls are currently winning the battle for control, the 14-day RSI is displaying a bearish divergence, as this indicator has failed to make a new high reading at the recent highs. Volume at the highs has also been less than stellar, which could signal that fresh buying has not emerged on the breakout. 950.00 remains resistance for the June contract, with support found at the bottom of the consolidation near the 875.00 area.