Tough Talk Rattles Bulls

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Stocks continued their bullish run for the bulk of the week before cooling off following what seemed to be intentionally scary comments from Federal Reserve Board members. Fed President Bullard said he could see interest rates rising as high as 7% before coming down. Another Fed member stated freezing rate increases was "off the table."

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The effect on markets was similar to throwing on the light, turning off the music at a party, then having a police officer lecture the patrons about the dangers of alcohol. It was a clear signal they wanted the bull party to end.

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The Fed is trying to curtail spending and a willingness to accept higher costs for everything in its inflation fight. That’s more difficult to do when people feel flush with stock profits and don’t care if their cars and eggs cost 8% more than last year.

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Did it work?

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For the moment, yes, but like rebellious teenagers, investors have a tendency to wait for the consequences before adjusting their actions. Those consequences will come on December 13th when the next inflation report arrives.

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This coincides with the next Fed meeting as well, where they will decide how much to raise interest rates and provide commentary on how much longer they will keep rates elevated.  A .5% rate hike is expected but .75% is possible and would crash the market. If it comes in at .75%, we’ll buy the SQQQ and look for a 25% gain.

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Buying option puts on the SPY for February/March can afford some opportunity though there is some risk as earnings may come down slower than anticipated, delaying the downturn.  The SH ETF, which shorts the S&P 500, can be safer as it won’t deteriorate in value like stock options do.

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What's Next?

Many are betting the Fed will start tapering the rate of increase of the interest rate hikes and provide a target date for stopping the hikes. We don’t see that happening in this next meeting. It’s much more likely that Chairman Powell will hike interest rates by .5% to .75% and continue stating they will remain aggressive in hiking further until inflation’s back in firmly broken, the economy is broken, or unemployment rates rise by 30%.

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We are a long way from those things happening. Investors will have to change tactics and embrace the reality of a 5% interest rate for an extended period of time, decreases to corporate earnings growth, and a likely recession late in 2023.

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If earnings and guidance comes in weak after the Fed rate hike and tough talk in December, the market will likely retrace back to previous lows. Right now, there is zero good news in the macro headlines, save for inflation coming down some. To take the S&P above 4150, the war in Ukraine would need to end and China would need to completely halt their COVID lockdown policy. These two situations seem unlikely, so that means we're going to be looking at a major market decline at the Fed meeting or in January or both.

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The Trading Plan

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From a trading perspective, this means growth tech stocks and consumer cyclical companies  will shed the gains they made over the past month. Stocks like TDOC, PAYA, SHOP, MA, MELI, AMD, PRCH, Z, and AAL which has been rising on the hopes interest rate increases will slow and inflation has peaked will be poised for 15% drops. It also means a stronger U.S. dollar value which punishes large international companies like Apple and Microsoft in foreign exchange rates.  These companies have been writing off billions in losses every quarter and that trend will continue.

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A few months ago, we noted that the discount retailers were poised for a comeback, given the lower costs of importing goods given the strong dollar and lower shipping costs. They also benefit from mid-market shoppers seeking out better deals from the bargain stores like Five Below, Big Lots, CostCo, and Walmart. The group is up significantly since then, so we hope you profited. There's still a lot of upside for Big Lots and the high short interest means there's high risk of a short squeeze if they report a great quarter.

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Fears of a Fed-induced recession from high interest rates will likely send more investors into these names seeking safety, driving up share prices further.  Walmart’s recent earnings report and monster buyback is evidence of the trend.

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Generally, stocks hold up better during earnings seasons when there are major macro events. That is likely setting us up with a big downturn after the 13th of December.  If earnings come in light in the first quarter next year, the market will deteriorate further, with the top technical experts believing the market will decline 17% from current levels.  

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As we have ben saying all year - the best play is to stay mostly in cash and trade on events. Not only is this safer, but the higher interest rates have money market funds paying over 3% annually in interest - higher than most company dividend rates.  

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Literally Dodging Bullets

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Last week, a stray missile landed in Poland killing two people and for a hot minute, we all thought the war in Ukraine escalated into a war against 30 NATO countries. Thankfully, the missile did not come from Russia and the situation was resolved peacefully. It was, however, a stark reminder of how close we are to a major world conflict which would upend the world and cause havoc on markets.

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Back to Buybacks

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A declining market means stock buybacks make more sense to companies. We’ll likely see extensive buybacks next year as companies use their cash stockpiles to stabilize their stock prices.

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Companies with the most cash and the biggest negative price moves will engage in buybacks. This will see their share prices increase when the authorizations are announced. We'll alert you when it happens, but sometimes it's good to plan ahead.

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ISEE A BIG OPPORTUNITY

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Iveric Bio (ISEE), which develops therapies for vision issues, was awarded Breakthrough Therapy designation last week for its drug that treats a type of macular degeneration affecting 1 in every 29 adults over the age of 75. The stock was up +25% on the event, and is up 74% in the past three months following very positive Phase III (late stage) clinical trials.

The designation is given by the FDA to companies that are bringing promising and needed therapies to market. It's often the step just before the drug wins approval to be sold to the public. For a small cap biotech, this often marks a significant milestone to achieving longer term financial success and major long-term upside to the share price.

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Level 2 Dollar Index Trade

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As the Fed raises interest rates and inflation comes down, the dollar strengthens. The strong dollar provides a chance to make some money by buying the U.S. dollar index ETF (UUP) and selling it above 30.

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Trading options on the UUP at a $29 strike price can be a 50-100%% gain on a UUP move to 30/share with a 2-3 month window or longer to de-risk the trade. The $29 strike calls are trading at 53 cents per contract.

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The UUP hit 30.7 after the last rate hike, and the dollar strengthens during recessions as inflation comes down.

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Knowledge Corner

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How to trade layoff news?

There's been a lot of high profile layoffs as of late - from Amazon to Cisco to Carvana to Redfin and Meta. As the supply-demand balance swings back in line, companies are cutting costs to save cash and boost profits. The layoffs affect stock prices in different ways depending on the company's situation.

Layoffs are a bullish event for established companies with solid, existing businesses and profits as they are viewed as earnings per share boosts which increases valuations. The bigger the layoff, the bigger the earnings boost.

For companies with volatile business models prone to sharp cyclical fluctuations and low or no earnings, the layoffs are often interpreted by Wall Street as a failed business model. For those companies, the share prices often fall.

Using the filters in the layoffs scenario, it's easy to see the differences in the event impacts and determine how to react to the latest layoff event.

Layoffs for established companies can provide great options action. Last week, Cisco calls on layoffs news jumped 120%, while the stock rose 5%.

META's layoffs drove share prices up 20% and we hope you took advantage following our premium alert to the opportunity.

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Key Earnings Announcements This Week

Nov 21:

• Dell Technologies (DELL)
• Factors to Watch: Global Chip Shortage, Supply-chain constraints, and Strong Demand.
• Zoom Video (ZM)
• Factors to Watch: Citi recently reiterated a sell rating on Zoom, post-COVID recovery, tightening IT budgets, and a weak outlook for new small business and customer contracts.

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Nov 22:

• Best Buy (BBY)
• Factors to Watch: Slowdown in Retail Sales, holiday season sales, and retail inventories.
• Dollar Tree (DLTR)
• Factors to Watch: Continuation of beating earnings estimates, a continuation of consumer budgeting, and the approaching holiday season.

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Nov 23:

• Deere (DE)
• Factors to Watch: Rebound of demand for agriculture equipment, rising commodity prices, and rising input costs hinder Deere's margins.

Economic Reports Due:

• Wednesday
• US Jobless Claims
• Russia PPI
• FOMC Minutes
• Thursday
• US Markets Closed for Thanksgiving
• Argentina Interest Rate Decision
• Friday
• Markets Close Early (1 p.m EST)

The LevelFields Team