Hedge against the Fed and Rejoice if You're Wrong

06/20/2019 5:00 pm EST

Focus: ETFS

Joe Duarte

Editor, Joe Duarte In the Money Options

Traders should prepare for all possibilities and hedge against the Fed while building a buy list, recommends Joe Duarte

Markets are increasingly skittish, and this week could decide what happens for the rest of the summer and perhaps the year. Stock and bond traders are aggressively betting that the Federal Reserve is either going to indicate that it will be lowering interest rates in the near future, or perhaps even pull the trigger by lowering rates at its upcoming two-day meeting. 

What could possibly go wrong? 

It’s tough to be a central banker these days and the Federal Reserve has a tough choice this week. Certainly the U.S. economy is not collapsing but it is in a state of flux. The problem is that things could change in a hurry. 

For one thing, aside from the Fed’s actions there are the ever present U.S.-China trade war issues along with the newly rising tensions in the Middle East, which could affect the oil market. Meanwhile there is the presence of algorithms in the market, which will magnify any event and potentially put volatility on steroids. 

What the market may have on its side is history. And since this the third year of the presidential cycle, the odds favor rate cuts, especially as the Fed doesn’t want a repeat of 2008 and doesn’t want to be blamed if there is a recession. 

It’s the Market-Economy Complex 

This time is different. In the past we had two separate entities, the market and the economy. And although there was a relationship between the two, there was enough distance between them so that what happened in the market didn’t always affect the economy fully unless the market trend remained in place for an extended period. In other words, the market often forecast what would happen in the economy. 

But times have changed. Since the repealing of the Glass-Steagall Act, the markets and the economy are intimately interconnected into a single entity, the Market-Economy complex. For many Americans, this connection is via the 401-k plan and the home equity line of credit (HELOC); both of which, in many cases fuel the average person’s wealth effect. 

No doubt, this linking of the markets and the real world has been further magnified since 2008 by the speed at which news travels through social media and by the adjustments the public has had to make to survive since then. And of course, the one thing that binds them is the general trend of interest rates. 

Consequently because of this connection and the advent of social media, everything happens at the speed of light in both places nearly simultaneously. In effect people will make real life decisions such as canceling vacations, reversing business decisions and waiting to make major purchases in hours and days instead of weeks based largely on the interest rate trend, the value of stocks and their composite effect of their 401-k plans and HELOC accounts. 

Therefore, because everything is now interconnected and news travels at the speed of light the effect of the Fed’s actions on Wednesday have the potential to disrupt both the markets and the economy simultaneously. 

Bulls are still not fully in control 

The New York Stock Exchange Advance Decline line (NYAD) made a new high on June 13 but could not extend it into Friday. That means we are still in a moderate state of doubt and that whatever the FOMC says and does on Wednesday will likely dictate the action for the intermediate term.

 

NYAD NYSE - Advance-Decline Issues index chart

The S&P 500 (SPX) rebounded after falling below its lower Bollinger Band before reversing and crossing back above its 200-day moving average, but is nowhere near a new high, given the laggard technology sector’s recently poor performance. SPX is now battling to move decidedly above its 50-day moving average.

$SPX Large Cap index chart

The Nasdaq 100 (NDX) struggled last week as bad news from the semiconductor sector rattled traders. The index remains above the 200-day moving average, but it is facing what could be very meaningful resistance at its 50-day moving average.

$NDX Nasdaq 100 index chart

The Fed and the Bond Market Hold the Key

It’s all about the Fed and the bond market now. Investors may be in for a wild ride on Wednesday afternoon after the FOMC releases its statement and Fed Chairman Powell holds his news conference. The U.S. 10-year Treasury note yield (TNX) is on the verge of new lows with the 2% yield area just nine basis points below the closing yield on June 14.

$TNX CBOE 10-Year US Treasury Yield index chart

The Fed’s decision will have a huge effect on the markets, but it will especially meaningful for two sectors: real estate investment trusts (REITs) and housing.

$SPRE S&P 500 Real Estate Sector index chart

For the past few weeks I’ve been pointing to REITs as market leaders. Accordingly, it will likely be a watershed week for the sector given the influence of the Fed on the bond market. REITs have been mirroring bonds for the past few weeks, thus if bonds tank, the REIT rally is likely to suffer or be completely done.

$SPHB S&P 500 Homebuilding Subindustry index chart

A similar picture is visible in the home builders sector as illustrated by the Invesco S&P 500 High Beta ETF (SPHB) where falling bond rates have spurred increased activity in mortgages. It will be interesting to see what happens in the home building stocks after the Federal Reserve rate announcement on Wednesday.

Hedge against the Fed and Rejoice if you’re wrong

It’s hard to trust the Fed, so anyone who trades will be well served by hedging their portfolio either through options or inverse ETFs. If I’m wrong, the odds that the market takes off to new highs for the next week or two should more than make up any losses from the placement of prudent hedges.

Since I don’t know what the Fed is going to do and how the market will react, I am preparing for all outcomes. First, I am keeping the stocks that are working in my portfolio but making sure I sell them if their sell stop gets hit. Second, I am hedging against the Fed. And third, and perhaps most important, I have compiled a buy list if the market rallies.

I added three hedges and six potential longs to my subscriber’s portfolio that can be accessed free of charge by signing up for a Free trial subscription to Joe Duarte in the Money Options by visiting the link below.

Joe Duarte has been an active trader and widely recognized stock market analyst since 1987. He is author of Trading Options for Dummies, and The Everything Guide to Investing in your 20s & 30s at Amazon. To receive Joe’s exclusive stock, option, and ETF recommendations, in your mailbox every week visit here.

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