Why this market can survive a beating

If a watched pot never boils, is it also true that an expected recession never happens? That seems to be the case now.

The bears have thrown everything but the kitchen sink at the global economy, from European debt crisis to a Chinese slowdown and now weak earnings forecasts, but the S&P 500 continues to make higher lows while the data points gradually improve. Several things are happening.

First, an army of self-appointed economic experts have decided that "financial crisis causes recession." Most of these are the same people who ignored the warning signs in 2008, and with the same lack of insight they recently predicted that budget problems in Spain and Greece would have the same impact as the U.S. mortgage bubble. The problem is that Spain and Greece were never central to the European or world economies, but U.S. housing was.

Second, these crises of Europe and Chinese weakness have been thoroughly anticipated for years. That's why coal, steel, and most emerging markets traded like garbage starting in early 2011. The mortgage crisis, however, wasn't expected; people denied the gravity of the situation all the way up through September 2008.

Third, the economic expansion in place since 2009 hasn't relied on borrowed money the way the 2002-2007 expansion did. (Except for the U.S. Treasury, of course.) The same is true in the stock market, where none of the recent gains in share prices were fueled by margin buying, put selling, yen selling or any other form of funny money that can suddenly be yanked away.

Fourth, and most importantly, the current economic growth phase simply hasn't lasted long enough to end. Most expansions keep going for at least five years, and the current one is less than four years old. This brings us back to the point about financial crisis: Other crises like subprime in 2008 or the crash of 1929 occurred when the economy was already teetering on recession. Contrast that with the October 1987 drop or the 2010 flash crash; both occurred amid the backdrop of a strong economy, and therefore no recession followed. The same is true of the recent mess in Europe.

So where does this leave us? At yet another great entry point, in my view. We've endured a full beating of bad news, and now I suspect that the market will start imagining positive headlines.

The U.S. economy will be the first focus, fueled by job growth and yesterday's strong manufacturing data. The aftermath of Hurricane Sandy will result in higher demand for all kinds of building materials . That means more gravel, cement, trainloads of lumber and more hours for workers who've been standing around waiting to get hired. (Such names as Lumber Liquidators, USG, and Louisiana-Pacific should watched as possible buys on pullbacks.)

Then we have the rest of the world. Spain and Greece will probably remain in a catatonic state, but the real story is China. Despite all the reasons to worry about the Asian giant, the data suggests that its economy is slowly accelerating yet again.

And the market is just now starting to price in this recovery. Coal miners and related stocks have been the strongest group on researchLAB over the last month. United States Steel has been making higher lows and copper giant Freeport-McMoRan just bounced at its 50-day moving average and is firmly ensconced above its 200-day moving average.

Then we have Japan's determination to devalue its currency, which has hovered at long-term highs for more than a year. This has a tendency to drive up commodities and stocks because traders can sell the yen like a free loan: Imagine borrowing $100 in yen now, investing it, and then having to pay back only $90 because the yen is dropping? That so-called carry trade was a huge engine for upside between 2000 and 2007, and everything is setting up for its return.

So here are some potential ideas. As usual these are starting points rather than outright recommendations:

  • U.S. Steel (X): Sell the December 18 puts for $0.35 and buy the December 25 calls for $0.35. It will cost nothing and could very well expire worthless. But selling those puts sets a buy order at a strong support level. If there is a quick rally this position will generate tremendous leverage.
  • Financials (XLF): This sector has paid its dues from the 2008 crash and many of its blue-chip members, including Bank of America (BAC), still trade well below book value. The charts refuse to break, and yesterday we saw short-term call buying in the XLF and BAC.
  • Short (PCLN): This stock has had an amazing run, but it's been making lower highs and lower lows. It is set to gap higher this morning after a strong earnings report, but if it stays below the September peak of $649, buying puts could make sense.
  • Cinemas and rental companies : These are two groups that don't get a lot of attention, but they've outperformed the broader market for the last year and are now coming back to life. See researchLAB for more.

Disclosure: I own FAS, which is triple-leveraged to the XLF.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Nov. 1.)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story


Other Topics


Latest Markets Videos