New Trade – $XLF: Exposure To the Elements

by Dan December 12, 2014 1:47 pm • Commentary

There is no shortage of explanations for oil’s more than 45% collapse since the 52 week highs in June. Many have focused on oversupply, while some (of late) are placing a greater emphasis on the lack of demand from what appears to be a weakening global economy.  It is my view that yes, it’s a deadly combination of oversupply and under-demand, but it could also be an unintended consequence of the Fed’s completion of quantitative easing. Commodities like crude oil were one of the primary beneficiaries of the global stimulus.

A Fed induced bubble is popping before our eyes and you can make up whatever reason you want for the price action, but there are likely to be further unintended consequences.

The chart below dating back to 2007 shows the price of crude oil plotted against that of the S&P500 (SPX).  What’s clear is that the SPX had already topped out in ’07 prior to the top in crude. In fact, while the SPX topped in October 2007, Crude went up another 30% before reversing and then losing 75% of its value from July 2008 to December 2008:

Crude vs SPX 8 yr chart from Bloomberg
Crude vs SPX 8 yr chart from Bloomberg

Equities led the way in 2007/2008 but this time around they don’t seem too bothered. Despite crude and the other industrial commodities’ collapses.  But as I mentioned earlier in the MorningWord, other asset classes / instruments are clearly showing stress:

In the past week, since the better than expected jobs data, the VIX has risen 70%. Yesterday it closed above 20 for the first time since October 20th (when the SPX was more than 100 points lower than where it is today.)  There is a growing angst amongst investors that has not exactly manifested so far in equity prices (at least here in the U.S), but is very visible in safe haven assets like U.S. Treasuries, the U.S. dollar. Conversely you see it in some increased volatility in the high yield debt markets and obviously with equity volatility products. Crude Oil is the main event and all discussions of price movements in other risk assets us start and stop with what’s happening in black gold.

So if you agree that part of the oil decline is a function of a Fed assisted asset bubble popping, while part is reflecting weakening global growth, then you have to ask yourself what comes next?

Yes the U.S. has been the place for relative strength. And yes the world we live in today does not have the leverage issues that we had in 2007/2008. But we have seen a reflation of risk assets in the past few years that has been in direct response to crisis stimulus measures that turned into monetary policy. And some of that is about to end. And when bubbles bursts we know that there can be reverberations. From the MorningWord:

The worry here is that the oil collapse causes all sorts of cuts in economic activity, including job cuts, with the potential of causing some sort of credit event.  Oil and related companies will start slashing dividends, risk defaulting on debt followed by some bankruptcies.

What will the knock-on effect be? Will we also see sovereign debt defaults in places like Russia, Brazil and Venezuela where their economies are so tied to the demand for crude?

Which leads me to bank stocks. These stocks are always right in the middle of every economic crisis, no matter what the origination. They just can’t help themselves. European Banks stocks (Euro Stoxx Bank Index – SX7E) already reflect strain, down 5% on the year, and now just a few points from the 52 week closing lows:

SX7E 1yr chart from Bloomberg
SX7E 1yr chart from Bloomberg

But in contrast to Europe the XLF (Spyder Financial Select etf)  is up 14% on the year. Although it was just rejected at a massive long term resistance level:

XLF 15 yr chart from Bloomberg
XLF 15 yr chart from Bloomberg

If you follow the oil slick from Feb Bubble bursting, to corporate defaults, to the possibly of sovereign defaults, even the banks of the most de-levered nation will not be immune to some sort of credit event.

XLF options prices have seen an uptick in the last couple weeks, with 30 day at the money implied vol nearly doubling, despite a mere 3% decline from 8 year highs in the ETF:

XLF 1yr chart 30 day at the money IV from Bloomberg
XLF 1yr chart 30 day at the money IV from Bloomberg

This tells me there are those who think the downward volatility in commodities and the stress in the high yield market can find their way into the banking sector.  Additionally, traders are bracing for the Fed to remove the language that they will keep rates low for a “considerable time” at Wednesday’s FOMC meeting.

A break below the recent consolidation at $24, and the Sept high of $23.88 could see a quick move back to $23 and if a little bit of hell starts to break loose, $22:

XLF 1yr chart from Bloomberg
XLF 1yr chart from Bloomberg

So XLF vol is NOT cheap, and the rise in vol with the muted price action in the underlying suggests that there are those who are getting a tad worried about the commodity collapse spreading.  Despite the rise in XLF options prices I want to have exposure with defined risk of a re-test of the October lows:

Trade: XLF ($24.40) Buy Feb 24/21 Put Spread for .55

-Buy to open Feb 24 put for .65

-Sell to open Feb 21 put for .10

Break-Even on Feb Expiration:

Profits: between 23.45 and 21 make up to 2.45, max gain of 2.45 at 21 or lower.,

Losses: between 23.45 and 24 lose up to .55 with max loss of .55 above 24

Rationale: If you have the sense that we’re just beginning to figure out who has all the exposure in this commodity collapse and that the risk could spread, the U.S. financial stocks, having just made multi year highs,, seem like a good fade. This structure goes out a few expirations and captures several other events as well like Fed moves and earnings.