Will the Stock Market Climb or Drop 10%? Here’s One Trade to Handle Both Scenarios.


Derek Jeter finally made it to Cooperstown this past week after his induction into the Baseball Hall of Fame was delayed a year by the Covid-19 pandemic. And while Yankee haters may quibble about some of the former captain’s statistics or shortcomings at shortstop, he stands in contrast to some of his prominent contemporaries who have been shut out of the Hall for suspected or admitted steroid use, most notably home run record holder Barry Bonds.

Also blackballed from Cooperstown is baseball’s all-time hit leader, Pete Rose. Charlie Hustle was banned from baseball in 1989 for gambling on the game while playing for and managing the Cincinnati Reds. That’s kept his name off Hall of Fame ballots. Rose claimed he only bet on the Reds to win. But baseball officials have argued that, if he’d ever failed to wager on a game, his bookies might have inferred that he knew something; maybe his starting pitcher was nursing a twinge in his elbow or a hangover, or both.

In this age of legalized gambling, down to having betting windows at Wrigley Field, however, Rose’s ban looks ridiculous, wrote Chicago Sun Times columnist Steve Greenberg this year. Assuming everybody in the stands and people betting on their phones from home have access to the same information, they can lose their money fair and square.

Compare that to the actions permitted for Federal Reserve Bank presidents. This past week, The Wall Street Journal reported that Dallas Fed President Robert Kaplan actively traded stocks last year. And Bloomberg disclosed much the same about Boston Fed President Eric Rosengren, whose favored investments included real estate investment trusts, a highly interest-rate-sensitive sector.

Both said they had complied with their respective bank’s code of conduct. But Thursday, Kaplan and Rosengren said they would sell the individual stocks they own and cease trading individual securities to avoid any appearance of a conflict of interest, the Journal reported. Instead, they said they would invest the proceeds in diversified index funds or cash.

Kaplan, a former Goldman Sachs banker, had multimillion-dollar positions in big blue chips, the likes of which would dominate a large, capitalization-weighted index fund. Rosengren, a less active investor, owned shares of a mortgage REIT, which essentially is a leveraged bet on interest rates.

Not only does the Fed set the overnight federal-funds rate, which influences the cost of mREITs’ liabilities, but the central bank also has been buying $40 billion a month of agency mortgage-backed securities, along with $80 billion of Treasury securities. Those purchases importantly affect the yield and price of the assets in the portfolios of the mREITs that Rosengren owned. It should be noted that the Boston Fed president has been among the central bank officials recently urging a reduction of the Fed’s massive securities purchases, which could potentially hurt mREITs.

It would seem that the Fed’s brass should be held, at the least, to the standards covering the lowest common denominators with the worst reputations: journalists, specifically those who cover business and finance. We at Barron’s aren’t allowed to write about stocks we own, engage in short-term, speculative trading, or trade options or futures. But our possible influence on a stock’s price pales in comparison to the Fed’s. Just listening to the Federal Open Market Committee’s discussions would immeasurably inform any investor’s decisions.

For those who aren’t fortunate enough to be in the Room Where It Happens, as the song from Hamilton goes, it’s harder to figure out what to do. That’s especially true with the major stock indexes hovering near records and at exalted valuations.

Juxtaposed against the S&P 500 and the Nasdaq Composite making new highs recently, the Cboe Volatility Index, or VIX, hasn’t made new lows. Historically, that combination has tended to precede a selloff, observes Julian Emanuel, chief equity and derivatives strategist at BTIG. “The catalysts are very obvious,” he adds, starting with the Fed. All eyes will be on the Sept. 21-22 FOMC meeting for some indication about the eventual tapering of the massive $120 billion monthly bond purchases, even if a decision isn’t officially announced until the Nov. 2-3 or Dec. 14-15 confabs.

Another thing to consider is the sharp deterioration in consumer sentiment tracked by the University of Michigan, which Emanuel says has been a very good predictor of an uptick in volatility, with stocks most likely moving to the downside. After the gains most investors have seen this year, with the S&P 500 up 19.6%, a long-term investor should prepare to be a buyer on a 10%-15% drop.

Emanuel’s year-end target for the S&P 500 is 4000, which would be about an 11% correction from the index’s current level. He puts a roughly 30% probability on that happening, but he also sees just as good a chance of the Dec. 31 number being 5000. Could we experience a repeat of 1999, during the melt-up in the latter stages of the dot-com bubble, when the major indexes also hit new highs without the VIX making a new low?

The BTIG strategist notes that algorithmic trading models have “learned” that they must be buyers at the 50-day moving average of the S&P 500, which has held through this year’s advance but lies less than 2% below Thursday’s close. A bounce off that level would probably extend the uptrend, while a breach of the key moving average could trigger a correction.

Given the possibility that the market could break higher or lower (and, sorry, we’re not privy to the conversation among the money mandarins at the Fed), Emanuel suggests taking advantage of relatively subdued options volatility with a “strangle trade”: the simultaneous purchase of an October S&P 4565 call option and an October S&P 4380 put option. The call would gain if the S&P rallies 1.6% from Thursday’s close, while the put would benefit if the index were to slide by 2.5% or more in the next month and fall through the 50-day moving average.

Finally, it’s hard to ignore the strong seasonal tendencies for market maelstroms this month and next. Some of Jeter’s most memorable moments on the diamond came during postseason play in October. Maybe it’s time to play defense.

Read more Up and Down Wall Street: Two Decades After 9/11, the Fiscal Wounds Run Deep Too

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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