By: Bill Spencer — May 10, 2020
Small-Cap Sunday - Did the Fed Just Hand Us a Quick 111%?
If you're one of the individual investors who has, or has ever had, a mother...
Happy Mother's Day to that great and good lady! That you're reading this now proves she raised you right and my hat is off to her.
In honor of Mom's everywhere today you're getting the "Mother of all hedging plays".
I call it that because it's going to give us a way to hedge against any coming market decline by getting bullish.
That sounds odd, I know, but in a second you'll see why it makes sense.
Now, I'm not calling for a new bottom. I personally think the balance of probability says we saw the low back on March 23rd.
But as you've read here more than once, a decline is quite possible.
And some people think the worst is yet to come.
This past Thursday the Bank of America (BofA) brought out a research note which claimed that 90% of its clients think the current market recovery is a “bear market rally”.
The BofA stressed that over the first week in May, investors withdrew $16.2 billion worth of capital out of stocks, and called it the largest weekly redemption since the March stock market swan dive.
The culprit was said to be something the Bank called "tech fatigue". And BofA pointed out that over the previous week, investors pulled $43 million out of tech stocks -- the first full week of outflows from technology in 2020.
That might be true, but it doesn't explain why the tech-centric Nasdaq Composite gained a full 6% over nearly that same amount of time.
(Click any image to enlarge)
And I would point out to the "bad news bears" that small-cap stocks -- as proxied by the Russell 2000 (RUT) and the S&P 600 (SML) -- crushed both the Dow Jones and the S&P 500.
Given their potential for fast and even meteoric growth, small-caps are what investors buy when they're feeling frisky during "risk on" markets.
(And yes, 'proxied' is a word.)
That research note by the BofA had one more very interesting finding, one that leads directly to today's "Mother of all hedging plays".
According to BofA, 70% of its clients report that they will only buy assets that the U.S. Federal Reserve purchases through its various stimulus schemes.
That's what we're going to do today -- buy an ETF that has a strong likelihood of being backstopped by the Federal Reserve.
iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is the largest high-yield bond ETF. It looks to track the performance of the Markit iBoxx USD Liquid High Yield Index.
That index itself is a rules-based index made up of U.S. dollar-denominated, high yield corporate bonds.
On March 23rd, as part of a gargantuan effort to keep liquidity flowing through the economy during the coronavirus pandemic, the Fed announced that it was creating two credit facilities tasked with buying as much as $750 billion in bonds.
The main goals are to prevent the financial system from seizing up, and also to help smaller companies maintain access to credit and financing over the short term, say the next year or two.
The Fed's efforts will focus on investment-grade corporate bonds and applicable ETFs, and HYG is one of the ETFs likely to end up on the Fed's shopping list.
So if the market softens and makes another leg lower, or even puts in a new bottom, owners of HYG and the other "worthy" ETFs can expect their investment to gain in value. This is all thanks to that 2,000-pound federal gorilla with infinitely deep pockets and zero sensitivity to bond prices!
In the spirit of "don't fight the Fed" we're getting into an ETF that's already benefited from the central bank's generosity.
On April 9th, when the Fed announced it would buy ETFs under its new Secondary Market Corporate Credit Facilities (SMCCF), investors in HYG caused the ETF to gap up +6.5% in one day.
Since then HYG has pulled back a little more than 3% and has entered a kind of "holding pattern".
I think what's happening is investors are waiting to learn exactly when all this bond buying will begin. So far the Fed has indicated that it would start in "early May".
As you can see in the image above, since falling -23% from February 25th to the March 23rd bottom HYG has retraced more than 50% of its losses. The ETF currently is finding support near $78 -- the 50% Fibonacci retracement level...
And it's meeting resistance near the next retracement level (61.8%) near $80.50.
Once the Fed starts buying, this ETF could recover the balance of its late-February losses and possibly reach $87.75, which would give us a 10% return.
And you won't need HYG to top out at $87.75 in order to see a double-digit return.
You can turbo-charge your profits by purchasing the November 74 Strike Call Option.
This particular option is a near-textbook example of a “Stock Replacement Strategy (SRS)” option. It has 192 days until expiry and a “delta” of .74.
The “ideal” SRS option would have 180 days until expiry and a delta of .75. The mid-price between the bid and the ask is $6.60.
Right now HYG trades for $79.75. If by the end of May HYG goes to $83.50 – a gain of less than 5% -- the Call will be worth $10.15 – a gain of almost 54% in barely three weeks. That’s a 980% annualized return.
If HYG does gain 10% and does reach $87.75 the Call will be worth $13.95. That’s a 111% or 1,929% annualized.
So we’ll sit back and see if the Fed is in our corner with this trade, like it was in early April when my friend and colleague Costas Bocelli played the Fed's bond-buying announcement like an Olympic gold medal pole-vaulter.
Costas got his Profit Skimmer readers into LQD, another corporate bond ETF that's very likely to land on the Fed's asset shortlist.
Eleven days later his readers banked a 48% profit return -- 1,592% annualized.
I mention this for two reasons. One, I'm so damned proud of Costas for the way he so consistently pulls off trades of this kind on behalf of his readers. (OK, I'm also a tad envious!)
And number two, I want you to get trades like that for yourself.
Give us a call at 855-822-0269 and ask for a seat at the table with Costas.
You'll thank me, I promise. The man's a genius.
Until next week...
Stay Safe and Sane.
Editor-in-Chief, True Market Insiders