Technical Damage Done and VIX Rising – Sell OTM Call Spreads.

June 9, 2008
Author: Peter Stolcers, Founder of OneOption

Last Friday the SPY dropped below major support (138) and selling pressure accelerated into the close. A much weaker than expected Unemployment Report and a $10 rally in oil raised fear. As long as people maintained their jobs, the "soft landing" scenario remained viable. Now that theory is suspect. The jobless rate made its biggest one-month spike in 22 years as the unemployment rate rose from 5% to 5.5% in the month of May. The employment rates from prior months were also lowered. Personal debt levels are very high and another round of foreclosures and loan defaults can be expected as people lose their jobs. Over the next eight weeks, another round of mortgage resets its will push homeowners into foreclosure. These rates have been creeping higher and the problem is spreading beyond sub-prime. Financial stocks have been selling off during the last few weeks of trading. This morning, Lehman reported a $2.8 billion loss and they raised $6 billion in new capital. They have reduced their leverage to 22% which is as low as they plan on going. The stock has been under pressure all morning. Two weeks ago, the Fed raised its expectations for unemployment, it lowered its GDP estimates and it raised its inflation expectations. It has encouraged financial institutions to raise capital and to get their house in order. This implies that they will be raising interest rates in the near future. The ECB is already leaning that way and they have not lowered their rates as we have. As US interest rates stay low relative to the ECU, the dollar continues to plummet. The earnings releases this week are extremely light and other news will drive the action. Wednesday morning, oil inventories will be released. They have shown a larger than expected draw for two consecutive weeks. The main reason for last Friday's surge was not related to supply. Israel stated that an attack on Iran's nuclear facilities was imminent. Unrest in the Middle East and the threat of another supply disruption pushed prices higher. This year, we are in a "La Nina" weather pattern. That increases the likelihood of hurricanes in the Gulf of Mexico. The futures are carrying a substantial risk premium and oil supplies are tight. Over the weekend, foreign markets held up relatively well. Oil is pulling back slightly and the market is bouncing from an oversold condition. If the bulls can't get something going early in the day, the bears are likely to push the market lower this afternoon. The technical picture is deteriorating. In today's chart you can see that the market is crowning and that the number of big down days is increasing. The VIX is also starting to move higher. These are bearish signs. On Wednesday, the Beige Book will be released in the afternoon and Friday, the CPI will be released. Those are the two biggest pieces of information in an otherwise quiet week. The current momentum favors the bears and prices are likely to test the downside once this bounce stalls. I still like selling OTM call credit spreads on financials, retail and restaurants. I am also adding defense stocks as a new sector to short. Ever since O'Bama won the Democratic nomination, defense stocks have been declining. As long as he leads the polls, these stocks are likely to come under pressure. image

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