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The Federal Reserve building in Washington.
Samuel Corum/Bloomberg
There is always a bull market. The trick is trying to find it.
Let the pundits wrestle with Wednesday’s sharp decline in the stock market. For serious investors, time and energy are better spent focusing on what may happen next—and positioning in advance of the move.
One of the most meaningful recent moves in the market was the strength exhibited this past week by the financial sector as the 10-year Treasury yield surged above 1.6%, a level last seen in October. On Tuesday, as the 10-year yield surged, many financial stocks strengthened too. The
Financial Select Sector SPDR
exchange-traded fund (ticker: XLF), the sector proxy, rose 2.6%, compared with a 0.1% decline for the
S&P 500 index.
The Treasury move pressured growth stocks and boosted value stocks—and especially financial stocks—which generated a lot of talk because Big Tech stocks have long led the stock market higher.
The financial sector’s outperformance offers a message to investors about what to expect in the future if rates rise. It suggests that the stock market increasingly anticipates strong performance from the sector at a time when the Federal Reserve is expected to end the easy-money policies that have long supported the market.
Financial stocks benefit from rising rates and from tumultuous trading in the securities markets. When rates rise, banks tend to make more money on their loans. If rates get too high, demand may suffer, but the expected increases are coming off historic lows. And the U.S. economy remains reasonably strong.
Investors bullish on the sector can get the options market to pay them for agreeing to own bank stocks by selling puts and buying calls with a higher strike price but the same expiration—a so-called risk reversal.
With the Financial Select Sector SPDR ETF at $40.10, the March $40 put option could be sold for about $1.40 and the March $42 call option could be bought for about 60 cents. The trade generates an 80-cent credit.
Anyone who considers the strategy must be willing to buy the ETF at $40. At $45, the call is worth $3. Over the past 52 weeks, the ETF has gained 39.5%.
The March expiration was chosen to cover two potentially important Fed meetings that could move the market.
On Jan. 26, the Fed’s rate-setting committee will conclude a two-day meeting. The bank is expected to announce that it will begin to reduce, or taper, its bond-buying program. Investors might even get more clarity on plans to increase interest rates from historic lows.
On March 16, the Fed will conclude another rate-setting meeting and publish its Summary of Economic Projections. Many investors think the Fed will vote to raise rates at this meeting.
The risk to the trade—indeed, to the entire market—is if the latest Covid outbreak forces the Fed to choose between supporting the economy and battling inflation. Most everyone seems confident the current Omicron outbreak is a temporary annoyance that will soon disappear and that life will normalize. Perhaps.
Still, it is hard to know how investors will react when the Fed begins to raise rates and when the expiration nears for the so-called Fed put, which has long supported the economy and market.
The financial sector trade lacks boldness—and that’s by design. The shift that is expected to soon occur could well represent one of the sharpest changes to the markets in the past 20 years. But just because everyone expects it doesn’t mean that everyone is prepared for what may happen. Let the market reveal itself. There is no need to be a hero ahead of what may be a turn in the trend.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.
Email: [email protected]
Source: https://www.barrons.com/articles/stocks-markets-fed-how-to-play-it-51641422196?siteid=yhoof2&yptr=yahoo