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By: Costas Bocelli — May 9, 2010

What's Likely Coming, and How to Play It

The great bull market rally is in serious jeopardy. 

From the March, 2009 lows in the wake of the credit crisis, the recovery has been stellar to say the least.  Economic indicators have shown positive gains, and first quarter earnings were a resounding success, with 80-85% of the reporting companies having met or exceeded expectations.

The Chart below is a 5 year flash on the S&P 500 illustrating the great rally.  As you can see, the S&P has successfully filled the gap from the Fall of 2008.  The Blue arrow signifies the demise of Lehman Brothers and the government seizure of Fannie Mae and Freddie Mac, the giant GSE’s that are paramount to the function of the real estate and mortgage markets.  This was the defining moment where credit markets and banking liquidity came to a grinding halt, systemic risk was on the horizon, and panic selling ensued.

With the extreme measures taken by the US Government (huge stimulus spending) and the Federal Reserve Bank (quantitative easing measures and flooding the system with free money), the markets recovered with lightening speed.

The Red line represents a major resistance point of 1220, as you can easily follow from right to left touching the Fall of 2008 and during the good times in 2006 and 2007 with the housing boom peaking.

To pierce this level in the short to intermediate term will take an unbelievable (irrational) exuberance that seems impossible considering what is unfolding in Europe.

The European Union, combined, has a GDP that is larger than that of the United States.  The sovereign debt crisis that is plaguing the weaker partners includes Portugal, Italy, Ireland, Greece and Spain (PIIGS).  These countries' debts are jeopardizing not only the Global recovery, but the existence of the European Union itself.

The market in the short term can follow three general paths:  It can continue the upward trend surpassing the resistance levels, stagnate or consolidate in a sideways pattern, or reverse and move lower. 

The upward trend seems the least likely path with this sovereign debt crisis looming. 

Second quarter earnings are going to be negatively affected from the flattening of the yield curve (ten year yields have fallen from 4% to below 3.5%) and the huge exposure US Banks have in European sovereign debt.  This will put pressure on US bank earnings. 

Also, the US Dollar has strengthened immensely, which will put pressure on US multinational revenues and earnings on companies such as IBM when they convert overseas revenues back to US dollars.  Another negative factor is the slowdown in growth and spending from the tough austerity measures that these European countries are taking to thwart the crisis.  All of these factors need to be adjusted in the earnings models.

The consolidation trend or sideways movement seems the best case scenario, where the US markets may hold their levels as money is parked in US equities at a measured pace.  If the crisis is somewhat subdued, this foreign money may provide some type of support.

The other trend is the ugly outcome, where the US markets are driven lower from the contagion of the European version of a credit crisis taking a toll on the US economy.  This scenario could cause the “double dip” recession economists fear and another leg of a bear market.

With this analysis in the short to intermediate term, consider profiting by purchasing premium collection PUT spreads on the SPY’s in June.  The SPY’s mirror the S&P 500 index, and the PUT Spread strategy will profit from a consolidation pattern and a selloff pattern.  This appears to be the side you want to be on that places the odds in your favor.

The premium collection PUT Spread has definable risk to what you pay for the spread, and creates a favorable return on investment.  The PUT Spread is constructed by purchasing an in-the-money PUT and selling an at-the-money PUT in the same month.  June expiration seems the ideal time frame.

With the SPY trading at 116.00 (equal to the S&P 500 at 1160), consider purchasing the 122 117 June Put Spread trading around 3.20.  Your total risk is 3.20 with the SPY at 122 or higher at expiration (equal to the S&P 500 at 1220).  With SPY at 117 or lower (equal to the S&P 500 at 1170), the spread will expand to 5.00, making a profit of 1.80 (ROI of 56% in 40 days).  Your break even is 118.80, or around 1188 of the S&P 500 index.

Another advantage to this strategy is that it can be applied to many Indices and ETFs that will see negative pressure from the EU debt crisis.  Also, individual stocks that have high beta’s to the broad market can be identified for the premium collection PUT Spread, such as IBM.

There is an old saying, “When life hands you lemons... make lemonade.”  In this case, “When the market hands you PIIGS, why not feast on the pork chops”.

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