March 18, 2013 - Can the Market Continue its Run?
The last several years have been pretty good for Wall Street. Actually, they have been better than pretty good, with the DOW at a record high and the S&P 500 sitting just shy of one. The NASDAQ is the lone index not trading near its all time high, which it set back during the dot-com bubble.
It would be easy to assume that the economy is in great shape, but that is not exactly the case. Unemployment is still high, gasoline prices are high, and the credit crisis in Europe continues to pose a significant threat to U.S. businesses. Despite the hurdles that the economy is facing, investors have remained upbeat. Since the start of 2013, the DOW has traded up 10.5%, the S&P 500 is up 9.3%, and the NASDAQ has managed to post a 7.6% gain.
But can the market continue its run?
The good news is that unemployment is gradually improving in the U.S. and has dropped significantly from its peak at 10% in 2009, but at 7.7%, it still has a long way to go before the recovery appears solid. Another cause for optimism is the improving housing market; we are no longer seeing the huge number of foreclosures that we were during the recession, and home prices are starting to increase. People feel richer when their houses are worth more, and that helps to keep money flowing into the stock market.
Inventories have been shrinking, and if this trend continues there is reason to believe that home prices will continue to improve. In addition, the Federal Reserve is likely to continue its monetary easing program, keeping interest rates at near zero, which will also help the housing market continue to improve. Finally, retail sales have been on the rise, and that is very important for the overall economy. There was some concern that a 2% jump in payroll tax at the start of the year would reign in consumer spending, but that has not taken place; spending was up in both January and February, and is expected to continue to grow in the months ahead.
It is a tricky market in which to predict whether the next big move will be up or down. There are valid arguments on both side of the debate, but for now, it appears as though the bulls are winning out. Understanding the optimism surrounding the market, but taking into account the uncertainty, the best way to play the market, in my opinion, is a hedged index trade. I like the iShares Russell 2000 Index (IWM), which focus on the small-cap sector of the U.S. equity market. Year to date, IWM has traded up 12.3%, so it is outpacing the major indices.
A nice hedged trade on IWM would be the June 84/87 bull put credit spread. In this trade, you would sell the June 87 put while buying the same number of June 84 puts for a credit of 37 cents. This trade has a target return of 14%, which is 53% on an annualized basis (for comparison purposes only), and has 7% downside protection.
Chart courtesy of stockcharts.com