A brief rundown on our open trades before we get to our latest.
Last week we reported that our IYZ/XLY 'spread' was profitable by about $25 per pair traded and that we were holding out for bigger and better things.
As of this last Friday's close, the spread widened just marginally to about $30 per pair traded, but we're still not satisfied. We believe in this one. Remember, it's a telecom vs. consumer discretionary bet that says the discretionaries have more to lose in a general equity selloff than the telecoms, as weak as the latter may be. Telecoms have essentially become utilities in the eyes of the market. They therefore stand to gain and lose much less than the broad market over time.
Next, the calendar spread that we posted on Valentine's Day has returned us nothing but love. Our original call was to sell the February SPX 1330 PUTS and buy the April 1330s. The Februarys expired worthless, putting $690 in our pockets and the Aprils have appreciated in value from our original purchase price of $32.20 to $59.00, a profit of 83%, and we feel conservative investors should now consider closing out.
Remember, too, that we sold the March 1330 PUTS last week against the Aprils and again pocketed the full load on Friday's expiration. That was another fat $4010 in the wallet for each option sold.
For those who choose to close out now – and who followed all our recommendations – your total take on the trade is $7380 on an initial outlay of $3220, or 129%.
For those who still expect more downside and want to hold the April PUTS a while longer, we'll have more to say later. In the meantime, best of British luck to you.
Speaking of the British
The beginning of the war in Libya marks a turning point for oil. Not so much for the price of the commodity – though that may be affected, too. More, we say, for the attention it starts to receive in the financial press as a rally killer.
We've already spoken about this a number of times: there's going to be a point at which the price of oil begins to put a dangerous choke-hold on the global economic recovery, and whether that begins at crude $105 or crude $110 – or whether it's already started, as we postulated a couple of weeks back – is less of a question. More important is the relationship between oil and the equity market, which we now believe is operating inversely and will cause significant downward pressure to be applied to stocks as oil appreciates.
Of course the war on Libya is also adding to the equity sorrows, as Colonel Qaddafi seems intent on blowing up important oil infrastructure upon nearly every military setback. And seeing as the Libyan rebels still maintain control over a large proportion of that country's oil assets, it's elementary that there will be further sabotage.
Middle Eastern woes, of course, are not limited to Libya. The Saudis and neighbouring Gulf States are having significant problems of their own, and most recently Syria, though not an oil producing state, is also heating up, with seven police officers killed in riots there and tens of protesters, along with the torching of several government buildings.
The danger with Syria resides in the conflict spilling into cross-border Turkey, Iraq and Jordan, where significant numbers of Druze and Kurd tribesmen harbour dreams of national sovereignty and are in open conflict with a number of those regimes.
Dramatis Personae
Another actor performing in the current oil drama is the U.S. dollar, which is now teetering at an important support pivot. Look here:
Given the current macro context, we're dollar bulls. But we're not going to fight the technicals, which at this stage look decidedly bearish. As we write, it appears that last year's support at roughly 75.60 is being taken out, pointing to continued weakness in the weeks ahead.
After that level, DXY 74.17 emerges as the next support. If there's going to be a turnaround for the dollar, everything will be predicated on DXY holding above that level. If there's a breakdown, the dollar will likely extend lower toward its all-time bottom at 71.31 (not shown on chart).
In short, continued dollar weakness will be a big plus for oil bulls, as crude is priced in U.S. bucks.
What's in it for us?
There are those who claim that the oil market is now in the grip of speculators, that there's plenty of oil to go around and that current prices have little to do with the supply/demand reality. Don't believe them. Saudi Aramco just raised its prices to customers in Asia and Europe by a significant margin. And that's not the kind of activity a country like Saudi Arabia, whose existence is dependent upon oil price stability, engages in while crude prices are surging and domestic unrest is beginning to seethe.
Therefore
This week, we're trading a variation of a theme we've been playing for nearly a month. It's oil related, and it pits the price of crude against the average consumer's ability to spend on discretionary items, even as he's forced to pay more to operate his vehicle.
Yes, employment numbers may be picking up, but real income is not. As the chart below shows, personal disposable income is taking a big hit from higher food and gas costs:
While average hourly earnings are up zilch in February and just 1.7% year over year, the cost of gas in just the last six months is higher by nearly 40%.
Our trade looks like this: we recommend you go long oil using the United State Oil Fund ETF (NYSE:USO), now trading at $41.93, and short the discretionaries with the SPDR Consumer Discretionary Select Sector ETF (NYSE:XLY), now trading at $37.86.
For every 100 shares traded (on both sides) your cost will be roughly $300, net commissions. The trade will become profitable as the spread between the two securities widens, but will lose should XLY start to close the gap with oil.
We'll be monitoring the trade with an eye to selling options against it, but in the meantime, keep an eye for yourself, and decide now at what point you're going to bail out with a loss.
Wall Street Elite recommends purchasing (NYSE:USO) shares and selling (NYSE:XLY) shares in equal numbers.
With kind regards,
Hugh L. O'Haynew,
Analyst, Oakshire Financial
