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Morning Update

This morning US equities are pointing towards a higher open despite lower markets across Europe. European stock indices have been trending lower after the decision on Greek aid scheduled for today was delayed. Fitch said saying they feel Spain’s debt rating is appropriate but Moody’s said that the ECB is only buying time for the Euro and their decision on France’s rating will be released in a few weeks. This has Spanish-German 10yr bond spreads widening to 450 bps, which is significant because it is the threshold where the LCH, a European clearinghouse, begins reviewing bonds eligibility to meet margin requirements.

One sector that has showed relative strength during last week’s broad market decline was the consumer discretionary sector, XLY. XLY is one of the best performing sectors year to date, up 15.43% versus an 8.36% gain for SPY. However, one option trader is betting that the good times are over for this ETF. The biggest option trade on Friday was the purchase of 2500 March 46/40 puts spreads for $1.69 with the ETF at 45.74. This is a bearish spread that profits if XLY is below 44.31 at expiration or 3.1% lower. This spread, known as a bear put spread, has defined risk and limited profit potential. The maximum loss this spread can incur is the premium paid or $1.69. If XLY is below 40 at March expiration (124 days away), this spread will realize its maximum value and return a profit of $4.31 or 255% return on risk.

Why get bearish on the Consumer Discretionary sector now? This is likely the expression of a broad view that US consumer spending will slow into the holiday season ahead of the fiscal cliff and slowing global trade. The last personal income report showed that consumer spending rose 0.8%, ahead of estimates and the largest gain since February. However, since disposable income growth– i.e. personal income after taxes and inflation, has been flat, it means that consumers used saving to finance their spending. This is not a sustainable way of fueling economic growth and means the next consumer spending report, due out on November 30th could disappoint the market. This morning the Japanese GDP report showed the economy shrank last quarter, and last week Mario Draghi stated that the debt crisis’ drag on the German economy is growing. With several of the world’s major economies slowing, the US could be the next. This is a low risk, high reward to play slowing consumer spending, which accounts for 70% of US economic activity. Because of the low risk, high reward nature of this spread it could also be used to hedge a portfolio of consumer discretionary stocks that could sell off if the US economy’s growth rate slows.


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