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Steve Smith Provides His thoughts on July Options Expiration

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The market continues to show a fair amount of resilience in the face of the ongoing issues in Europe, escalating tensions in the Mid-East and what to my mind seems like a lackluster earnings season thus far. I think the two things that are propping up this market is the notion that there simply aren't many attractive alternatives to US equities, and that as indicated by sentiment readings, a lot of people are equally befuddled and have a bearish disposition.

But the resolution of these two cross notions seems to be bearing itself out in the reaction to some earnings reports. While low P/E big cap names such as IBM, INTC, MSFT and GOOG (which I clearly misplayed) got nice pops off of “just not worse than expected” reports, the high-growth names like Intuitive Surgical (ISRG) and of course this whopping of Chipotle (CMG), shows that concerns for downside have evidence to support them. The relative underperformance of the Russell 2000 (IWM) is evidence of the vulnerability and inability of the market to gain any real upside momentum.

One thing I have to say about CMG is that while a single-day drop of 20% seems a bit of an overshoot on a relatively small disappointment, this move wipes out the straight-line run that the stock had from late December to April when it became clear it was hijacked by algo-based hedge funds. And, this liquidation could continue through obvious support levels as the first one at $320 has already broken. While the circumstances were slightly different, I’m looking at Netflix (NFLX) as reference; after the movie rental service's price hike resulted in disappointing earnings last September, the stock plunged from above $200 to below $100 in a matter of weeks. Once the these stocks lose their momo, it’s hard to say where they will stop. That said, I may be looking at selling some put spreads on Chipotle, maybe the $300/280 in the next week, but I will tread very cautiously.

While the valuations of the big-cap dividend payers may have limited downside thanks to an underlying bid for yield, I have to question whether there can’t still be further p/e price compression in coming months. This earnings season shows that corporations are still able to reap near-record bottom-line profits despite a significant slowdown in top-line revenue growth. This is what helped propel stocks off the lows in 2009 and 2010 as productivity and margin gains offset sales weakness. In 2011, the question became, could corporate profits continue to expand at what was basically the expense of the consumer as job and wages remained under pressure?

While there was a reprieve as global economies seemed to gain some traction, I have to wonder if the productivity gains haven’t been pretty much squeezed to the bone. At some point, the inability of the workers to purchase the products they were making will be a further drag on sales, and as demand flags, it will result in the reversion of margins vs. p/e valuations that have historically been cyclically correlated. That is, with margin compression could come further p/e compression. Could the S&P trade at 10x earnings? I think so but I’m not ready to bet heavily on it quite yet.

All that said let’s close out the positions that expire today and next week we’ll look for some other shorter term opportunities.

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POSITION:  No positions in stocks mentioned.