Buy Calls Ahead of the ADP Report. FOMC Minutes Will Be Neutral Today – Rally After the Release

April 3, 2012
Author: Peter Stolcers, Founder of OneOption

Yesterday, the market briefly dipped into negative territory and it spent the rest of the day in rally mode. China's PMI and ISM manufacturing were better than expected. The S&P 500 should challenge multi-year highs this week. Credit concerns in Europe are still subdued, but interest rates are creeping higher. PIIGS are releasing 2012 budgets and they lack credibility. Economic conditions across the EU are soft and this dark cloud will reappear in May. Germany's central bank dispelled rumors that it would not accept PIIGS debt as collateral. If European central banks adopt this policy, interest rates will climb quickly. The ECB added €200 billion to its "firewall" and that should temporarily reassure investors. The news calendar is light today and the FOMC minutes will be released mid-day. A month ago, the rhetoric was fairly hawkish. The Fed talked about improving economic conditions and the possibility of inflation. Since then, Ben Bernanke has softened the tone. I believe the FOMC minutes would have been bearish if not for the Fed Chairman's recent comments. The zero rate policy will remain intact, but QE3 is on the shelf. Personally, I believe the Fed should state that there won't be a QE3. Fed actions don't pack any punch and the law of diminishing marginal returns is kicking in. At some point, the economy has to recover on its own. If the Fed rejects QE3, it would signal strength and confidence. The big news will hit tomorrow. ADP employment will be released before the open and it has been an excellent predictor for the Unemployment Report in recent months. It generates a huge reaction and the actual jobs report has been irrelevant because the good news is already priced in. The consensus estimate for ADP employment is 217,000. Initial jobless claims have been dropping steadily the last few weeks and I believe the estimates are conservative. Warm weather across the US has construction workers back on the job much earlier than expected. Homebuilders have reported strong results and the guidance has been excellent. Warm weather should also be positive for retailers. Easter has come early and that will strengthen March's results. After the open tomorrow, ISM services will be released. It blew away estimates last month (57.3) and the consensus estimate is for 56.7. This number should be in line and it will fuel the rally started by the ADP release. The market is closed on Friday and traders will not want to get caught short. They will aggressively bid for stocks and that buying should start after the FOMC minutes are released today. Mutual fund money flows into equities have been strong and we are in "risk on" mode. Individuals are funding retirement accounts ahead of the April 16th deadline. That money will find its way into the market now that is making multi-year highs. Over $6 trillion is parked in short term debt and that money will continue to rotate into equities. Next Tuesday, Q1 earnings season will kick off. There have not been many warnings and Asset Managers will buy ahead of the releases. Stocks have rallied into earnings season for more than 10 straight quarters. Some of the biggest and strongest companies release early in the cycle and optimism jumps. I believe this market still has a really good push left in it. Credit concerns in Europe are subdued and economic growth in China has stabilized. These dark clouds are off in the distance and investors will focus on domestic strength. Corporate earnings are strong, balance sheets are solid, stock valuations are attractive (forward P/E of 14), global central banks are easing, interest rates are at historic lows, inflation is contained and 75% of our banks can withstand an economic depression (according to the stress test). The market momentum points higher and I don't see any news that will stand in the way of this rally. Stocks have had time to consolidate gains and they are ready to break out. I feel that cyclical stocks (rails, heavy equipment, chemicals) have the most upside potential. The earnings will be fair, but the guidance will be strong. These stocks have lagged and they have room to run. I am long calls and I have 65% of my normal position on now. I am not hedged and I will be gradually taking profits once the SPY trades above 146. In three weeks I believe the rally will stall and all of the good news will be priced in. We could get a correction in May. That move will seem bearish, but in reality, we will be slightly lower than we are today (SPY 138). If you are not long, I suggest buying some calls today. Once the ADP report hits, it will be too late. image

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