You would think that a decline in oil prices would be a boon for consumers: with less money required to fill up the gas tank, there’s more disposable income to buy new products and services. If you combine that situation with today’s low interest rates, we should be witnessing a consumer revival. However, the numbers don’t quite bear that out.
The Christmas holiday season was one of the worst on record for companies in the retail space. Most have been talking down their numbers with no end in sight. So, what’s happening? Have consumers become savers, putting that excess disposable income to work in their retirement funds?
Certainly, you could point to demographics as a key element in the consumption shortfall. Perhaps aging baby boomers are more interested in having a strong balance sheet than a new car or a TV.
Then, there’s the income disparity facing millennials. This generation very possibly will not attain the wealth and income metrics of their parents, a situation that our economy has never seen. So, savings at the gas pump may be highlighting a much larger problem.
A simpler explanation
Of course, there could be a simpler explanation: it’s possible that consumers’ predilection to save has more to do with disbelief than any change in mindset. Simply stated, consumers may be unwilling to accept that oil prices will remain at such depressed levels.
If that thesis is correct, there will be a point – presumably, in the third or fourth quarter of this year – at which consumers will accept the reality of lower oil prices and begin to spend their savings. That certainly would provide the oomph that the economy needs.
North American equities are well positioned, should we see a shift in consumer sentiment. The sell-off that has taken place since the beginning of the year has been predicated upon the lack of consumer spending, potential job losses in the oil-producing regions of the U.S. and Canada, and the prospect of higher interest rates later this year.
This triple threat has pushed stocks lower, much in the way you would push a beach ball under water: the deeper the ball gets, the harder it is to hold down – and the reaction when the pressure is released is immediate and significant.
Imagine a scenario in which there is no increase in interest rates, oil prices stabilize in a range that does not affect employment in the oil-producing regions and consumer skepticism abates. Take away this so-called “triple threat,” and equities markets will react in much the same way as a beach ball being pushed underwater.
Two distinct approaches
There are a couple of ways to play a potential turnaround in North America’s equities markets. The first is to simply buy “close to the money” calls on broader indices, such as S&P 500 depositary receipts (SPY; recently priced at US$199). A long call will provide leverage with limited risk, although time will be working against you; because of this time consideration, financial advisors might look at calls that have at least four to six months to expiry.
Another strategy is to employ “bull” put spreads on indices with SPY or iShares Nasdaq 100 index ETF (QQQ; recently priced at US$101). A bull put spread involves the sale of an “at the money” put with the simultaneous purchase of an “out of the money” put.
For example, with QQQ ETF at US$101, you could sell the QQQ May 101 put for US$4.25 and purchase the QQQ May 90 put for US$1.40 for your clients. This particular bull put spread generates a net credit of US$2.85.
As the QQQ May 101 put obligates you to buy QQQ ETFs at US$101 a share, you want the index to rise so that the short option will expire worthless and your client will retain the net credit. At any QQQ ETF price above US$101, both options expire worthless and the net credit is the maximum profit.
The maximum risk on the trade occurs if QQQ ETF trades below US$90 a share at the May expiration. But even in this worst-case scenario, the loss is limited to US$8.15, which is the difference in the strike prices minus the initial net credit received when the puts position was established.
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