The stock market shrugged off the release of the Fed’s late-April meeting minutes on Wednesday, as bullish traders chose to interpret the release as an indication that the Fed will push back its interest-rate liftoff. In truth, the minutes simply downplayed the likelihood of a June rate hike, which the futures market had already priced at a 0% probability, and seemed to indicate a likely September hike.
The dollar has gained strength and the euro has weakened, as I projected in the Big Deal #1. Oil has also tumbled. But the market’s reaction to the Fed minutes on Wednesday signaled a reversal in these trends, albeit a light and I think temporary one. Below are five-day charts for the euro and oil, as gauged by the CurrencyShares Euro ETF (ticker: FXE) and the United States Oil Fund ETF (USO).
As you can see, oil is bouncing back more firmly in early trading today, rising above its 20-day exponential moving average/ Bollinger band midpoint. Part of the gains are due to traders’ overzealousness regarding the Fed minutes, and I suspect someone from the Fed will come out and make a statement indicating the market’s misinterpretation of its plans, should assets begin behaving as if rates are unlikely to rise by September. This is a headwind risk most traders aren’t accounting for.
There just isn’t much upside left in the U.S. stock market. Case in point: Home Depot (HD) reported better than expected earnings and sales in the first quarter on Tuesday, the same day U.S. housing starts rose 20.2% to their highest level since November 2007, but Home Depot shares fell 1.74%. The next day, Home Depot-rival Lowe’s (LOW) reported worse-than-expected sales and earnings, and Home Depot’s shares fell again – this time, on fears of increasing competition, as Lowe’s might cut prices. But if better-than-expected earnings and sales – and raised guidance for the full year – on top of bullish sector news and a stumble by your chief competitor can’t send the shares of a quality stock like Home Depot higher, what will?
This, of course, is reminiscent of how market-leader Apple (AAPL) sold off after reporting what some market watchers deemed the greatest quarter by any firm in the history of commerce, and Facebook (FB) and Disney (DIS) also lost ground in the wake of blowout reports.
Goldman Sachs (GS) says buybacks and dividends are all the S&P 500 has left. The investment bank was proven right on Tuesday, when shares of McDonald’s (MCD) surged 2.71% after it issued 2 billion euros and $2 billion worth of new bonds. The company will use the funds to finance buybacks and dividends, but it’s surprising the market sent the shares higher after European investors flat-out rejected McDonald’s 20-year tranche at auction. The EU and the euro may not be around in 20 years, and for that matter, McDonald’s might not either – at least not in its present form. The firm was downgraded by Moody’s, S&P, and Fitch earlier this month.
As you can see in the chart above, shares of McDonald’s have already sold off quite a bit from their post-bond-issuance highs on Tuesday. This was a no-brainer short-term short, but I think there’s still opportunity to the downside. When quality stocks like Apple, Disney, and Home Depot can’t take the overheated market higher, then the worst performers are bound to fall. McDonald’s shares have been gaining since late April, but they’ve been mostly jawboned higher by the company’s new CEO, who unveiled a turnaround plan former Reagan official David Stockman compared to Nixon’s “secret plan” to win the Vietnam War, i.e. nothing but bluster.
What’s more, the dollar’s continued strength will weigh on McDonald’s already anemic results, since 57% of the burger chain’s business is done overseas. Same-store U.S. sales declined in 14 of the past 15 months, and the declines have been much steeper in international markets. In the U.S., millennials have no interest in McDonald’s, and consumers in general are saving rather than spending their money. The recent uptick in gas prices makes consumers more cautious, too.
Finally, if I’m right and interest rates rise faster than perma-bull traders think they will, then McDonald’s will likely come under more pressure as a high-yielding stock. Yesterday, when the market took the Fed minutes to mean a pushed-back rate hike, high-yielding stocks like AT&T (T) and General Electric (GE) posted outsized gains, as did utilities. Dividend-payers are more attractive when interest rates are low, and less attractive when interest rates rise. McDonald’s pays a 3.3% yield, the same as GE.
With our outstanding play on Phillip Morris International (PM) good until September, I think it’s appropriate to make a more aggressive play on McDonald’s. I’m looking at its June puts, which expire in 29 days. Shares of McDonald’s were trading at $99.44 as of 11am ET, and I like the stock’s $100-strike June puts, which had a $2.95 ask at that time. Fifty-six cents, or 19% of the total, was in intrinsic value.
To help finance the purchase of these puts, we’ll sell an equal number of McDonald’s $95-strike June puts, which were commanding a $0.73 bid as of 11am ET. Our debit put spread would therefore cost us around $2.22 before commissions, allowing us to enter the play across 9 contracts on each leg in order to stay within our $2,000 trading budget.
- We’ll buy MCD’s $100-strike June puts.
- We’ll sell MCD’s $95-strike June puts.
We’ll aim for 20% gains on this play.
McDonald’s Corporation (MCD)
1) PM $80/$82.50 September debit put spread
- Entry price and date: $0.97 on 5/18/15
- Current bid/ask: $0.59/$0.94
- Target: $1.15 bid
Shares of Phillip Morris have done nothing but go down since we entered the play, and yet our long $82.50-strike puts on the stock haven’t performed. It’s pretty astounding we haven’t been able to clock any gains thus far. Just look at how Phillip Morris has performed during our time holding its puts:
Our enemy on this trade is the market’s unshakable faith in low interest rates and higher stock prices. The VIX remains at historically low levels, indicating traders don’t anticipate much downside risk. This makes puts inexpensive, even as select underlying stock prices fall. Below is a year-to-date chart of the VIX:
Given these conditions, I’m confident in holding our September put spread on PM, while entering a more aggressive put spread on McDonald’s. If things aren’t going our way by early next week, then it may be wise to look into some select call spreads – perhaps even credit spreads – to hedge our bets, going forward.