Market momentum is Green. The market rallied on the back of positive economic news, helping to push the S&P 500 to the top of the channel from early June gains. But, I’ve noted that we are approaching overbought conditions in this market, and we have a few critical data points arriving.
Yesterday, I talked about the eight stocks with a perfect F-score of 9, a solid valuation, and a Z-score north of 3. The list had a lot of value here. At the center of the list, we saw a company like CF Industries (CF), which operates in the agricultural fertilizer industry. Now, I look at this environment right now, and the momentum is positive.
But – this rally is getting a little long in the tooth. If we look at this rally from the bottom on June 17, 2022, we see that the Relative Strength Index (RSI) of the SPDR S&P 500 ETF (SPY) has gone from 32 to almost 68.
This would signal a move from nearly oversold conditions to nearly overbought conditions. So, I have to be a little conservative right now on trying to carry on the massive up moves and anticipate that something could shift quickly.
But a trader is going to trade. And an investor will invest. So, if I’m looking at this environment, I know that CF Industries (CF) is quality. Its recent lows in June and July were around the $80 level.
And both times, the stock found support and bounced higher. So, what can I do to take advantage of this company – one that I’d be happy to own at $80? The answer is a credit spread.
Trading CF Industries
So CF Industries has an F-score of 9 and a Z-score of 3.48. Its buyout multiple is also quite low. It had a great earnings report. And it operates in a sector that we’ll need BADLY in 2023.
If you thought the fertilizer crunch was bad this year, wait until we get the final results of our harvests and witness supply shortages hit various places around the globe.
So, $80 is my target. The September 19, 2022 $80 put trades for about $1.10 right now. I can sell that put and buy the $77.50 put for protection at $0.80. That means I can generate $30 in a credit on top of $220 in the margin.
That is a return of 13.6%, and my breakeven price for CF shares is $79.70. This is important. Because on this trade, I am risking $220 – and only that amount if the stock falls to $77.50. (The “put” that I would purchase would allow me to sell the stock at that strike price.)
But if I bought 100 shares of CF Industries today, it would cost me $9,692, based on today’s closing price. If the stock fell to $7,750 because of a negative momentum event or market selloff… I’d be down more than $1,900.
So, this allows me to trade smaller, have access to shares if the pullback happens to the breakeven level, and actively trade with less risk. In addition, I’d likely want to set a stop loss here of maybe 100%. That way, the most I can lose would be about $30 instead of the full amount. I urge this because of something I want to show you about this rally.
Long in the Tooth
This market rally has really been something. I note that the last time that we had a profound market rally – driven on the back of the Fed’s statement – was in March. Back then, the market rallied above the level of the previous negative movement in the market.
Why does this matter? We’re currently at the support level of the last time that the market broke on June 8. And right now, I’m looking at the SPY, which has an elevated RSI level…
And Apple (AAPL), the biggest stock in the index is right at the line of an RSI of 70. In that situation, I definitely want to exercise some caution. A high RSI and high Money Flow Index (MFI) for AAPL have largely coincided with market short-term tops.
And if we get CPI data that is well ahead of expectations, the next leg of this market downturn is staring us in the face. There are many structural problems that this market has not properly priced in over the last few months.
Rent prices, long-term energy prices, ESG, and the decoupling of global supply chains will likely leave inflation entrenched in this economy for not just months… but likely years…
And those conditions of longer-term inflation (even if it’s 4% a year) will likely create a whipsaw market like we’ve experienced in 2022 for the years ahead. It’s a very good time to learn how to trade momentum… and how to capitalize on the assets that will experience higher moves due to entrenched inflation.
The market has priced in the odds of a 4% Fed Funds rate for February at just 0.7%. I think the odds should be somewhere around 40% to 50%. Enjoy this rally while it lasts. A storm is coming again soon.