The stock market is at a very important crossroads here, and following this morning’s hot CPI results, the reaction to this data could determine market trends over the next 3-5 months. While I remain bullish, I am acutely aware of the macro, fundamental, and sentiment-based risks facing this market at all-time highs. We outline our approach to dealing with the potential for a pullback from the post-CPI record high that would cast doubt on a 2024 Fed rate cut. I use the S&P 500, Nasdaq 100, and options hedges that I may implement personally and for research and asset management clients. I can only recall a few other times in the past 20 years where I was so focused on trying to figure out where the market was going over the next 3-5 months. And after a thorough study of all the market data points and indicators we are watching, we can say that the next 10%-15% move is either higher or lower than here. Let me explain. Following a brutal bear market in 2021 and 2022, the stock spent most of 2023 on the rise, only to hit new all-time highs. The S&P 500 weekly chart shows a basic 5-wave Elliott trend, consisting of three separate market increases labeled 1, 3, and 5. Intervening between these market rallies are two market corrections, labeled 2 and 4. This is a textbook. This pattern predicts a correction to recover between one-third and two-thirds of the previous rally, with a downside target of $4,385 to $4,020. The reasons are numerous: persistently high inflation numbers, solid GDP and fourth-quarter profits, and a tightening that suggests the four or five Fed rate cuts many are expecting may not materialize this year. The labor market continues. How will the market react to this recognition? I think a process of recognition is happening now, but the depth of this correction of recognition is not yet known. However, after an incredible market recovery, I don’t think now is the time to panic and remove too many chips from the table. I think it may be time to introduce option hedging. Introducing a Hedge Based on the chart above, we estimate the put debit spread for S&P 500 monthly options for July to protect against a “likely” correction to this 5-wave rally. Specifically, you are considering buying 4,500 July exercise puts and selling 4,200 July exercise puts for a total cost of $21.00, or a premium of $2,100. The spread is 300 points, but you pay 21 points, so if the S&P is 4,200 on July 19th, your total risk is $2,100 and you could potentially earn as much as $27,900. SPY can also be done 10 times smaller, so you would pay $210 to earn $2,790. How many spreads should you do? Well, it depends on what you want to protect. To keep things simple, let’s say you want to hedge a $100,000 portfolio that has a high correlation to the S&P. A drop to 4,200 would be a 16% decline from here, resulting in a potential drawdown of $16,000. If you bought 6 SPY put spreads, your premium cost would be $210 x 6 = $1,260, giving you a potential gain of $16,740. Are you saying the market will correct? Probably, I don’t know. But what I can say is how amazed I am by the incredible resilience of the market as we move into an age of technology that very few people really understand. The frightening market correction we just endured in 2021 and 2022, combined with the exponential era of AI development and adoption that is currently accelerating, suggests that we may have only just begun. There are some things you need to keep in mind. The Nasdaq 100 just hit a new all-time high on the heels of its second-worst correction since 2000. We could be on the brink of a multi-year rally. That’s why I like to pay for S&P 500 puts. Spread your insurance policy and don’t give up some of your major holdings like Netflix, Spotify, Nvidia, Celsius, etc., which we discussed in previous articles. Disclosure: (Gordon owns SPOT, NFLX, CELH, and NVDA) both personally and in the asset management business. Chart shown is Optuma) The above is subject to our Terms of Use and Privacy Policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any security or other financial asset. The content is general in nature and does not reflect your unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of your own financial or investment advisor. Click here for full disclaimer.
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