May 2nd, 2023

Is The Fed Signaling Rate Cuts?

There is an expectation that the Fed will start cutting rates in the Fall, however, if the cuts are postponed, it will likely result in a significant drop in EPS estimates for the second half of 2023 and the fiscal year of 2024.  This would put pressure on stock prices in the broader market.

The S&P 2023 EPS estimates are sitting at 18.72x, making stock valuations relatively expensive. Any misstep in earnings, rate cuts, or an unforeseen crisis could be too much for the markets.  

With the Fed meeting coming up, we need to hear the Fed change from their normal phrase, “In determining the extent of future increases in the target range…”  to something that mentions “changing the future target range.”  

The market is assuming the Fed will signal a pause to rate hikes, but if they don’t mention changing the future target range, we can assume the Fed plans on keeping rates higher for longer.  

The Fed has six remaining meetings this year and we are fairly sure we’re going to see a 0.25 rate hike in the upcoming meeting.  

The market is looking for rates to drop by 1% by the end of the year.  That would mean the Fed can’t keep rates elevated for long or if they do, they would need to implement two aggressive 0.50% rate cuts in the last two sessions of the year.  

While I think there are discounts out there – I’m underweight on stocks.

NetEase (NTES) is a  company with ties to online games, music streaming, and internet content services in China and internationally.  

They have a history of increasing sales and earnings per share year-over-year.

They’ve been on a nice upward trend for months.

The implied volatility of the stock is near single digits, (12 out of 100), so options may be priced below value.  

The stock has earnings coming up in May and that’s part of why the stock has a strong seasonal track record over the next 7-week period, rising in 14 of the last 22 years, giving it a historical accuracy of 63.64%.  The average move in the next 7-week timeframe is 11.51%.  

I’m looking at a debit spread, which involves buying an option and selling a further out-of-the-money option.  Since we don’t have July expirations to choose from, I’m looking at the September 15th expiration date.  

I’m looking at buying the $85 strike and selling the $110 strike.

A debit spread gives you a profit graph that looks like this. 

You will achieve max profit if the stock closes above $110 by the expiration date, but as long as the stock moves up from the current level, you may be able to close the trade earlier for some profits. 

Since it is a debit spread and the breakeven-at-expiration is higher than the current price, you need to monitor the trade closely and be ready to exit quickly.  

This trade carries a negative theta, which means the spread will decay with each passing day if all other things remain equal.  In other words, this trade will lose value as time passes unless the stock moves in an upward direction.

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Jeff Wood

Editor, Filthy Rich Dirt Poor
Coach, Options Testing Lab

Any trade or trade idea discussed is for educational purposes only.  They will not be tracked as an official trade recommendation.