Houghton and Atkeson

Trading the Truth

by Houghton and Atkeson   05/12/08

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Editor's note: While Sam Collins is on vacation through May 15, OptionsZone.com contributors and professional traders Andrew Houghton and Nick Atkeson are taking over the Daily Market Outlook as guest columnists.

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On Friday, we discussed the bond vigilantes -- which were prominent earlier in this young millennium -- as an example of market participants who ignored the political and corporate rhetoric of the time and used their capital to express their opinions in the marketplace.

In other words, they traded the truth. To some extent, we are all vigilantes -- not acting as an organized group, but still using our capital to buy what we think is going up and sell what we think is going down.

OIL SURGES (EVEN) HIGHER

Speaking of things that are powering upward, oil hit another record on Friday as the front-month futures contract on the NYMEX closed up 1.8%, or $2.27, at $125.96 per barrel before hitting $126.27 in aftermarket trading.

There is much rhetoric at the moment about the cause for the incessantly increasing price of a barrel of crude oil.

A recent forecasting survey conducted by The Wall Street Journal showed that 51% of the respondents said that fundamentals (i.e., demand from China and India) were the major factor in the price rise. Additionally, 41% of this same group said demand was also the main factor in rising food costs.

Constraint in supply came in as the second-most-favored response, with 15% using this as the reason behind crude's price increase and 20% explaining the rise in food costs with it.

If the percentages attributed to the aforementioned supply-and-demand reasoning behind crude's move higher are added together, they total 66%. This would leave all of the other reasons -- including the "speculators" the government is currently blaming -- to fight for the remaining 34%.

The reality is that 34% of anything isn't a majority and that, even if the entire 34% were all speculators, getting them all to do the same thing at the same time would be an impossible achievement.

Additionally, If OPEC sensed something of a speculative nature occurring, it would be sure to do whatever was needed to wrest control back into its hands. Throughout the years, this body has repeatedly flooded the world with oil to knock the price down to levels where upstart producers and alternative-extraction methods (i.e., oil sands) became uneconomical -- thus regaining pricing power as a result.

PRICES, WORRIES RISE FOR CONSUMERS

With oil at $126 per barrel, there is also the concern about inflation. This Wednesday, we get a look at that data in the form of the Consumer Price Index. According to the Dow Jones News Service, consumer prices are expected to rise 0.3%, which translates into a 12-month increase of a rather tepid 3.6%.

Stripping out food and energy (because apparently none of us eat, and most of us don't drive or use hot water and electricity), those rates are expected to be 0.2% and 2.4%, respectively.

Numbers like the latter might cause the Fed to breathe a sigh of relief, but a recent survey from Reuters and the University of Michigan found that consumers themselves expect inflation to be 4.8% during the next year and an average of 3.2% a year over the next five years.

There was also some uncertainty expressed by those polled as to how much the economic slowdown would help to reduce these expectations.

THE WORLD (NO LONGER?) ON TIME

FedEx (FDX) issued a profit warning after the bell on Friday, citing "unrelenting" fuel-price increases and softening demand. The company said its fuel costs have increased 7%, or $100 million, since March when it issued its last outlook for the current fiscal quarter.

While fuel costs might be the attention-grabber here, as it plays nicely with the "Record Crude Price" headlines we see multiple times each day, the softening demand the company mentioned should not go unnoticed.

FedEx's business forecast has implications for the broader economy, as online purchases, business contracts and other items that have an immediacy attached to them are often shipped this way. It says something about where the economy is headed when something absolutely, positively, does NOT have to get there the overnight.

With a slowing economy, interest rates close to all-time lows and soaring commodity prices, it is no wonder that the U.S. dollar (as measured by the DXY contract on the NYSE) closed at a low of 71.191 on April 22. In the face of these three factors something interesting has happened since then, however: The dollar has started to rise.

Not by much, mind you, as Friday's close of 73.05 is just 2.61% higher than April's low and comes after a 14.36% decline starting on June 14, 2007, with a close of 83.128. It's enough, though, to be above its 20-day moving average and to have broken the 80-day moving average on an intraday basis on May 8.

WHERE SHOULD YOU SPEND YOUR INVESTMENT DOLLARS?

So if we go back briefly to our opening comment that the vigilantes are really just people who put their money where their mouth is, it would seem that the longer-term effects of inflation are beginning to attract attention.

A stronger dollar is just the realization that the United States will have to raise rates at some point to battle the inflation caused by the current low-rate environment. Those higher rates will make the dollar a more-attractive currency to hold for participants in the world markets.

The good news here is that not only will the dollar increase in value but, while holding those dollars, foreign investors will buy dollar-denominated securities -- adding more potential cash to fuel the next move up in stocks.

While the macroeconomic effects discussed in today's note may well take some time to play out, it is probably a safe bet to think that the lows established in March will hold. For now, however, investors should stay away from companies sensitive to higher fuel costs -- constituents of the Dow Transports Index (DJT), for example -- as well as manufacturers that use petro-chemicals in the production process, including Dow chemical (DOW), DuPont (DD), Agrium (AGU) and Eastman Chemical (EMN).

The financials will benefit from the foreign investment -- when it comes -- but the last harangues of the credit crisis would caution one to dollar-cost-average their exposure in this area during the remaining months of 2008.

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Andrew Houghton and Nick Atkeson work together to identify unusual options trading activity on the "big money" (i.e., institutional) level and regularly contribute their findings to OptionsZone.com.

For a timely look at big-money options trades taking place under the radar and independent of the headlines, visit Andrew and Nick's full archive of Unusual Options Trading Activity by clicking here now!