FedEx & Economy Track Lower - Your Money September 16th 2022
Posted by Steve Bokor
We would not place a lot of weight on stock market performance this week. Yes, August inflation increased from an expected -0.1 to +0.1 erasing hopes for an end to the current inflation spiral, but the reaction of Tuesday reminded us of the type of irrational sell off we saw in February 2020. Granted the core inflation rate rose even more, and the subcomponents are less sensitive to the impacts of rising interest rates than items like food and gasoline (you still must eat and typically drive to kids to school on their way to work) but the reversal in prices looked more like a lack of buyers to offset the selling pressures from derivative trader’s liabilities holdings. Yes, that was a mouthful and needs some explaining.
When an Options Trader (Market Maker) sells a call option to an investor, he gives the buyer the right to buy 100 shares of XYZ from him at a set price, for a set term (say the next month) regardless of where the stock is trading. This is entirely different than when an investor buys 100 shares of XYZ in the marketplace. That transaction takes place between a person that wants to sell their position and an investor that wants to buy a position.
With Options, more often than not, the seller is a professional “market maker” and does not own the stock and is effectively creating a short position for their account. When they sell a call option, they agree to sell you 100 shares of the stock at specified price for a fixed term. They are in it to make money and collect a “premium” or the cost of the option, but they must also make bets on where the stock is heading and will typically buy 100 shares of XYZ in stages and put it in his “inventory account”. However, when XYZ stock prices go the wrong way, an option buyer’s loss is limited to the premium paid. For the Options trader, their losses can be greatly magnified.
Take FedEx for example. It closed on Thursday at $204 and opened today at $159. Imagine the hit a “option market maker” might take. If he sold 10 call options to you (the equivalent of 1000 shares) on Thursday with a strike price of $204, he theoretically would have simultaneously bought 1000 shares of stock at the same time to protect his liability against FedEx rising to $205 or higher. But that did not happen and at 6:30 Friday morning his $204,000 worth of stock is now worth $159,000 as the price of stock fell.
Now imagine 50 “market makers” all trying to limit their losses at the same time today and to make matters worse, the options they sold yesterday expire today. Now imagine that happening on 1000 different companies. it creates chaos at a whole new level. It is why the NYSE traded 3.5 Billion shares today versus a normal 1.1 billion shares when option and futures contracts are not expiring.
As for Tuesday’s action when the Dow 30 dropped 1277 points, there were a lot of option traders all trying to offload positions and as the market continued to fall, the option traders were forced to sell more and more exacerbating an already thin market. Meanwhile the small option investors who spend a few hundred dollars each, also lost money but it is multiplier effect of option contracts that cause the market makers to lose large sums of money and cause increased volatility in the process.
Now back to investor sentiment. Back in June, the Federal Reserve stunned the market with a 0.75% hike in interest rates followed by another 0.75% hike in July. It was hoped that falling gas prices and perhaps discounts at retailers for other goods through the summer might have meant the Federal Reserve would not be as aggressive on the 21st of September. Their summer mantra has been “we will do whatever it takes to get inflation back under control and to our target of 2%.
The bobble heads on the business channels and blogs started to speculate that perhaps a softer inflation number might elicit a 50BP hike next week. That hope was dashed when inflation edged up not down. Furthermore, it sparked speculation that rates might move up 1%. We think not. We believe Mr. Powell and his cadre will stay the course with measured increases, but the big question is what will they do on November 2nd and December 14th. By that time most of Corporate America will have delivered third quarter earnings and we suspect they will be lower than Q2, plus by December, investors will have a third quarter GDP stat to digest. You may recall both the 1st and 2nd quarter delivered negative growth rates and personally we did not see enough data to convince us the third quarter will be any different.
The big stumbling block continues to be the extremely strong labor market. Yes, we are starting to see layoffs and job losses, but rail workers have tentatively agreed to a 24% wage increase plus $5000 in bonuses. According to one estimate we read, that will provide them with back pay of apx $11,000. The rail companies will be forced to either absorb that wage cost or pass it on to customers who will likely in turn try to pass it on to end users. Bottom line, wage inflation will likely remain sticky until the economy really softens and that is what scares Wall Street the most in our opinion.
Mind you it is not all bad news out there. We note Ukrainian forces are gaining back huge portions of their country thanks to efforts by Western nations supplying them with weapons, medicine and technical know how, and we believe China will continue to do what it takes to get its economy back on track. That bodes well for desperately needed parts for North American companies plus increases demand for our raw materials. We continue to believe in long term bull cycle for energy and probably explains why oil prices held up this week. Natural gas however came back down to earth on a combination of lower temperatures and reports of building inventories in Europe.
Finally, there is a quasi holiday on Monday to honor the death of Queen Elizabeth, so expect TSX action to be lower with bond holders sitting on the edge of their seats waiting for Tuesday’s CPI for Canada.
Happy Trading and Stay Safe.
Cheers Steve and Michele.
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