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Morning Update

This week all eyes will again be on the fiscal cliff negotiations in Washington, with comments from Congress driving the market. Over the weekend The Hill reported that Boehner offered to increase the debt limit for one year though Boehner said shortly after “Any increase in the debt limit will require a greater amount in spending cuts” which seems to negate any progress that had been made and puts the negotiations back at square one. Last Thursday and Friday the spot VIX index rose, and the Dec. contract, which expires Wednesday, rose in lockstep with it. However, the Jan. contract actually traded down on Friday, which suggests the market is only fearful in the near term and predicts the VIX to fall into Jan. expiration. The below average amount of contango between the Dec. and Jan. contracts is somewhat of a bearish sign for this week, and could mean the market sell off if comments out of Washington continue to disappoint.

As the fiscal cliff nears the market is beginning to wonder what going off the cliff will mean for the US economy. One sector likely to be among the hardest hit by the fiscal cliff is the defense sector, which is highly dependent on government spending for revenue. Lockheed Martin CEO Robert Stevens recently said that going off the fiscal cliff would be “devastating.” That is because sequestration would mean funding cuts to all discretionary accounts, including a flat 9.4% to defense and 8.2% across non-defense programs. The stock ended lower by 3% last week and saw unusually high put volume on Friday. The biggest trade of the day was the purchase of 20,000 Jan. 80 puts for $0.40 with the stock at 89.59. This is a bearish bet that the stock will be below 79.60, 11% lower, at Jan. expiration.

Friday Lockheed Martin signed a contract with the Pentagon for an order of 32 more F-35 Joint Strike Fighters at $107MM apiece. The development of this fighter jet has been plagued by cost overruns which has made it the most expensive weapons program in US history and made it a symbol of military wastefulness. Last year it was estimated that the total cost to the Defense Department for 2,443 of the planes desired, along with their operating expenses, would be over $1 trillion, or larger than the entire GDP of Australia. With so much government money going to defense companies like Lockheed Martin it is difficult to imagine a fiscal cliff deal that does not cut at least some of the Pentagon’s defense budget. The big question will be how much of this budget gets cut, and that is anyone’s best guess.

Buying puts on Lockheed Martin is one of the better ways to play the fiscal cliff. As we approach the end of the year without a deal, the stock is likely to sell off. If we do get a deal, it is still likely to include some cuts to the defense budget, which could also push this stock down. The key to this trade is to keep a favorable risk/reward profile by buying Jan. puts that are about 10% out of the money. If Lockheed Martin approaches the strike bought I would take profits on the trade and move on to the next instead of holding short stock after expiration.

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