So, it's quite possible that after the Fed says nothing new but "we're still on hold for the most extended of extended periods" that stocks surge through S&P 1,300 and Dow 12,000 and volatility continues to drop. Bernanke and Co., ever watchful of the downside risks for the economy, aren't about to let up their battle against the specter of a Japan-style deflation. They will do more than risk stoking inflation -- they will feed it everything they can to make sure it reveals itself. And only an admission that this long-term plan is finally working will bring about the opposite outcome and a flight from risk back to cash. My sense is that internal Fed sentiment is building tension toward the inflation argument. But we may not hear that yet today.
Only if there is enough tension in markets as they slowly wind tighter like a spring, and enough tension on the FOMC as members look incredulously at one another about policy, could it take only a nudge to send markets spinning. Is this a huge tipping point? I don't think it is; to me, it just seems "a little too quiet" right now when we know QE is working and we know it will eventually have to be unwound. Markets are ready and waiting, anticipating that day and only waiting for the nod.
Yesterday, I wrote about the peculiar appetite for risk expressed in currencies like the euro and British pound. And I wondered what happens when the Fed says "game over" on QE, or even as much hints it's beginning to lean in that direction. I believe that Big Ben and the crew will unwind slowly and give markets plenty of warning. It's part of his character to act with steady, discernible, measured calm when it comes to monetary policy. He's been predictable in this way for two years now.
And even if he sends an uncertain signal, or a deliberate one of policy shift, I think markets will overreact to the downside for a few days or weeks and then resume their trajectory with the V-recovery economy. The Fed's medicine of the past two years may indeed cause inflation to some degree. But it was necessary medicine. We want inflation tomorrow much more than we want deflation today.
So how might we hedge or profit should volatility return and equities hiccup? I like a put spread on the SPDR Dow Jones Industrial Average ETF (DIA) or the "diamonds" right now. I already own SPDR S&P 500 ETF (SPY) 125 puts for February expiry and I've lost money on those. But I can't resist the volatilities in DIA and will risk a little to have more downside protection. Here's one way to do it:
Trades: Buy to open DIA February 119 puts for $1.42 and sell to open DIA February 114 puts at $0.37.
The net debit of $1.05 based on yesterday's closing marks.
Volatilities here are trading around 12. It has been cheaper, but not by much. And if you like the idea, but want to buy more time for it to play out, the same strike put spread in March is trading for only $1.40. Again, markets can continue to climb the "wall of doubt" and volatility can go lower. But if you need a relatively inexpensive market hedge or you want a different way to trade this month's inflation debate, this might be it. If you have other better ideas, say using the iShares Barclays 20+ Yr Treas.Bond ETF (TLT) or ProShares UltraShort 20+ Year Trea ETF (TBT), I'd be happy to hear them.
At the time of publication, Kevin Cook was long SPY puts.
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