Charting the Bernanke Collar

I've been studying the stock market's four-year cycle for quite some time in this space, and over the past few weeks, I've been entertaining two different hypotheses.

Hypothesis One

My working assumption had been that the four-year cycle low came ahead of schedule, forming in July and launching the new 2006-2010 cycle. The July-February rally sent the S&P 500 from roughly 1220 up to 1460.

On the vertical axis, the first chart below plots the market's percentage gain off the July low (represented by the black line), along with the median four-year cycle performance since 1962 (the blue line) and average performance (red line). The gray lines measure one standard deviation from the median.

The horizontal axis measures the number of trading days from the launch of the new cycle; this particular chart plots only the first two years of the cycle. Let's take a look:

Source: TheAgileTrader

The black line had been moving along pretty much as expected, just a bit below both the median and mean lines, until late February, when the SPX dropped sharply all the way down to the -1 standard deviation line, from about +18% to +11%.

That drop on the black line came at a time when weakness was to be anticipated, as is visible on both the blue and red lines, but it was much more sudden and sharp than I expected. And this variation from my expectation led me to hypothesize that it might be appropriate to shift what I consider to be the end date of the 1998-2002 cycle from October 2002 to March 2003. In turn, that would shift the launch of the 2002-2006 cycle, and then the launch of the 2006-2010 cycle from July 2006 to perhaps as late as April 2007, turning it into the 2007-2011 cycle.

Hypothesis Two

Such a shift would change the plotting so that the 2003-2007 cycle would look more like the next chart, in which the thick red line shows the course of this 2003-2007 progression.

Source: TheAgileTrader

In this plotting of the current cycle, a precipitous downside continuation would be in store for the SPX between now and mid-April, at which point a new four-year cycle would begin.

Two very different scenarios, right? In the former scenario, the SPX would move to new highs from the early March sell-down, continuing to creep higher for roughly three more quarters before leveling out into a choppier trading pattern. In the latter scenario, the SPX would tank hard into April before launching into the new four-year cycle and a more aggressive uptrend that would probably take the index up at least 25% during the remainder of this year.

But here's the curious part: While the two scenarios are quite different in the near term, if we set our horizon for the end of 2007, we get very similar targets.

In the former scenario, if we assume that the SPX could rise to the +30% level by the end of 2007 (six quarters into the current cycle) -- that is, 30% above the July 2006 low near 1225 -- we get a year-end target of about 1592.

In the latter scenario, if we look for the SPX to descend to the +55% area (that is, 55% above the March 2003 low to 1240) and then to rally 25% off that +55% level in the subsequent three quarters, we get a target of about 1550.

During the next month, whether we get a precipitous selloff that takes the SPX down 200 points or so, or we get continued modest strength that keeps the market pushing ahead to new local highs, my cyclical work suggests that the original SPX year-end target of 1550-1600 is a sensible one.

The Bernanke Collar

Moreover, all this mathematical fiddling fits hand in glove with how the markets are reacting to the Fed's tinkering with policy language. If the SPX were to suddenly drop 200 points, the Fed would probably be more likely to ease rates, and that could readily spark market strength in the second half of the year. And if the SPX were to continue creeping higher, the Fed would be more likely to hold rates steady, which, at this point, would probably disappoint the stock market, somewhat muting its second-half advance.

There's always talk about the "Greenspan put" (and now the "Bernanke put"). That term means that the Fed chairman has given the market confidence that if things get too bad, he'll loosen monetary policy, preventing a stock market crash. It's like the Fed has already bought put options on the stock market or, functionally speaking, taken out insurance to prevent a crash.

If we're going to give the market's anticipation of Fed policy a name, then I believe we should call it the "Bernanke collar." That is, it's like the Fed is short an out-of-the-money call (a call sold at a higher strike price) against the market and long an out-of-the-money put (at a lower strike price).

If the market goes up, then the Fed will hold rates steady or raise them. (There's a cap on the market, which is like being long stock and short a call.) And if the market goes down, then the Fed will lower rates, putting a floor on just how large a loss the market will incur (like owning a put as insurance).

So, what does this so-called Bernanke collar look like? Let's look at one hypothetical collar using S&P Depositary Receipts (SPY - commentary - Cramer's Take) as a surrogate for the SPX.

Let's say the SPY is now at $143.39. Suppose we sold a January 2008 $155 call against a long position of 100 SPY shares. Then let's say we also bought a January 2008 $140 put. Using an implied volatility of 13 and a risk-free interest rate of 5.25%, here's what the position's risk/reward graph would look like at expiration.

Source: TheAgileTrader

The black line on this chart shows what the gain/loss on a long position in SPY would look like at all the points between $123 and $163. The yellow line shows the value of the short $155 call, the red line shows the value of the $140 put, and the blue line shows the value of the net position, or the Bernanke collar.

If we hold this Bernanke collar position, our maximum downside at expiration in January 2008 is $699 if the SPY trades lower than or at $140. If the SPY is greater than or equal to $155, the maximum upside is $801. If the SPY closes right where it is now on Jan. 19, 2008, the Bernanke collar loses $360 (excluding the dividend, so in reality, the numbers are just slightly better than this).

That's what a collar looks like: It has both limited downside risk and limited upside profit potential. With the Fed in data-dependent mode, ready to raise rates if inflation grows too onerous and/or cut rates if growth becomes too anemic, I believe the Bernanke collar is a more apt analogy than the Greenspan put.

Conceptually speaking, the Bernanke collar ties in nicely with the cyclical study above, which suggests that whichever way the four-year cycle plays out in the near term, a year-end target of SPX 1550-1600 remains sensible.

In last week's euphoric response to the FOMC's "lightening" of the tightening bias, the bond market's reaction makes the equity market's reaction look a little suspect.

While the real yield in the five-year Treasury inflation-protected securities (TIPS) market (represented by the red line in the chart below) did rise from a low of 1.99% to 2.03%, suggesting that expectations for economic growth had improved just a smidge from their worst recent levels, the break-even inflation rate rose even more to 2.49%, its highest level since August.

Source: TheAgileTrader

With the trend in growth expectations (red) falling and the trend in inflation expectations (blue) rising, it's tough to see what the market was so happy about last week. If anything, the Fed's (perhaps) less-inflation-hawkish reference to "future policy adjustments" in its policy statement, which replaced the phrase "additional firming," may have itself increased inflation expectations.

In this case, the Fed might only be able to refrain from tightening if they talk the hawk's talk. If growth expectations fall durably below 2% and/or if inflation expectations rise toward the 3% area, then the Fed will have some serious problems on its hands.

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At time of publication, the Dynamic Trading System remained on short-term sell signals for the SPX and NDX, and traders in its managed programs remained in bearish positions in exchange-traded funds, Ultra, Rydex, and Futures accounts.

Adam Oliensis is president of Dog Dreams Unlimited, a guaranteed introducing futures brokerage, and editor of the trading service The Agile Trader. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Oliensis appreciates your feedback; click here to send him an email.