Is The Fed Finally Done? Here’s How to Prepare For Its Next Decision
The Federal Reserve is talking tough about raising interest rates. But so far, after July’s rate hike, all we’ve seen is talk from the central bank. Meanwhile, the bond market’s been doing all the heavy lifting and the rise in bond yields may be good enough to cool things off in the economy and to keep the Fed on the sidelines.
I’ve been working on the simple premise that the current trading pattern in both the stock and bond markets in October 2023 resembles what we saw in October 2022. That’s because, now, just as then, a combination of rising interest rates and extreme pessimism is unfolding. In October 2022, the combo led to a top in bond yields and a stock market bottom which spawned a multi-month rally in stocks that lasted until August 2023.
Certainly, the action in the market will change daily, especially during earnings season and in the current geopolitical climate. Thus, there is no hurry to commit any new money to the market immediately. Yet, given the potential for a sudden change to a bullish trend, it pays to be prepared.
In this article, I will update where things currently stand and consider, without forecasting, what may lie ahead and how to prepare for the possibility via a time tested trade.
Signs of Economic Moderation Appear
The Fed’s pause suggests that even though official data such as the Consumer Price Index (CPI) has suggested inflation may reignite, the central bank is leery of pushing the economy into a recession. There is some supporting data for such caution, culled from the recent PMI report, which suggest that the economy may be stabilizing and inflation may be cooling:
- Manufacturers are seeing a modest but not overwhelming rise in new orders;
- Service providers (a major source of wage pressures) are reporting a slowing in business;
- Exports are falling suggesting a slowing in the global economy;
- Expectations of lower costs are rising translating into the ability for businesses to hire at stable wages and expand capacity without raising prices;
- Fewer employees are leaving jobs reducing the need for new hires and reducing wage pressures; and
- A reduction in material prices is slowly evolving.
When you add the lack of a major explosion of crude oil prices into the mix as a response to the ongoing tensions in the Middle East, you can see that the Fed may have some room to maneuver, at least when it comes to not delivering any more rate hikes, in the remainder of 2023.
The Stock Market is Working on a Bottom
As in October 2022, familiar signs of a market which is forming what could become a tradable bottom are emerging. Of course, there are no guarantees, and any bullish developments may be short lived given the geopolitical uncertainties of the moment.
Nevertheless, the New York Stock Exchange Advance Decline line (NYAD) is testing its March 2023 support level after breaking below its 200-day moving average. These are not encouraging signs.
The key indicator is the RSI (Relative Strength Index), which is trading near 30. If NYAD makes a new low but RSI does not, the odds of a rally will increase. It would be more bullish, however, if NYAD just held above the March lows.
Preparing to Trade a Bottom
Trading is an uncertain business; thus, preparation is required. Before trading the long side, especially during tricky periods when the market can turn on a dime, make sure support levels hold. In this case, that means waiting for NYAD to hold near its March lows decisively and to show signs that it’s mounting a credible rebound. This could take several days or longer to become evident once the bottom is put in place.
Once conditions are optimal, a great way to trade the general trend of the market is via the Invesco QQQ Trust ETF (QQQ). This ETF offers a great opportunity to cash in on money flows into large cap technology stocks which account for almost 40% of the weighing in the ETF.
Moreover, QQQ is well diversified into other sectors of the market including companies which manufacture consumer products, and are involved in energy, biotech, and other areas of healthcare. That means that its tech related gains will be boosted further by a broad advance in stocks, such as what would be likely if the Fed made it clear it was done raising rates.
Recently, despite its current short term choppiness, this ETF has held up better than the overall market. You can see its recent bottom is much higher than what’s evident on the NYAD above.
As a result, it’s better positioned to move to new highs than other trading vehicles which must make up more ground. In the short term, QQQ’s trading pattern may be bumpy as conflicting earnings between Microsoft (NSDQ: MSFT) and Alphabet (NSDQ: GOOGL), are confusing investors. And before moving in, make sure the ETF holds above its recent support which is $350.
To lower risk, you can use a call option, such as the January 19, 2024 $370 Call Option (QQQ240119C370000) which recently traded near $11 per contract. For this trade to deliver maximal gains, QQQ would have to trade at $370 or above by the expiration date of January 19, 2023. That would require a gain in the ETF of $11 or so based on the closing price on 10/25/23. That’s the type of gain which could easily happen under the right market conditions such as if a major rally erupts over the next few days to weeks.
In addition, an option trade allows for participation in the overall trend of QQQ with a much lower risk of loss, as 100 shares of QQQ would require an investment of $36,000 at recent prices versus a much lower purchase price of $1100 per contract on the option.
The option offers two more advantages. If QQQ falls in price, the most you can lose is your purchase price per contract. A rise in the price of QQQ will lead to a gain in the price of the option, which is limited by the usual option parameters such as time value decay as applicable. On the other hand, if QQQ moves above $370 by January 19, you can exercise the contract, which would let you own the ETF shares at $370. You can also close out the trade with any unrealized profit prior to expiration.
For example, if QQQ’s price rises to $400, you would be able to buy 100 shares valued at $40,000 for $37,000; realizing a gain of $3000. Remember, if you still own the option and it is in the money (above the strike price) at expiration, you will be assigned the shares and your account will be debited.
The Federal Reserve may be close to being done raising interest rates. Of course, there are no guarantees and much can happen between now and the end of 2023. The stock market is not out of the woods yet and volatile trading may still go on for weeks before a tradable bottom develops.
Yet, it makes sense to prepare for a bullish turn ahead of time. A simple way to participate is via shares in a liquid ETF, like QQQ, whose shares usually follow the market’s trend.
To lower risk, once optimal conditions are evident, you can use a QQQ call option.
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