October Positioning

New Plays on PPH, DA, and NKE

Dear Bottarelli Research Member,

You probably don’t even realize this, but we just experienced the Dow’s best Q3 performance in the last 11 years. Now that we’ve put a bow-tie on Q3 and are officially starting Q4, the big question on everyone’s mind is, “when will we witness the seemingly inevitable correction?”

Although that’s an important consideration, the more important question for traders like us is “How do we position ourselves to profit off the seemingly inevitable correction — yet still profit if the markets continue to rally?”

As I prepared by due diligence over the weekend, some very familiar themes continued to pop up. Most notably, some of the major financial publications are getting more aggressive with their opinions about high-risk lenders. CBSMarketwatch, for example, ran an expose on the looming mortgage risk titled “Lenders Gone Wild.” Barron’s followed up with a story of their own, where they revealed that the bank’s real estate exposure now stands at 55% of their total assets, which is a record high. At the same time, these same banks have dwindled their loan-loss reserves down to a 20-year low. All of this continues to support my bearish thesis on companies like Wells Fargo (WFC – NYSE), but for some reason these high-risk mortgage banking stocks continue to trade higher, seemingly immune to the troubles they face on the horizon. Hmmm.

Another troubling theme is that consumer spending, adjusted for inflation, dropped 0.1% in August. This is concerning because the one thing the economy always seems to fall back on is the non-stop spending patterns of the American consumer. If we begin to see continuing signs that spending is being curbed, you’ll see less Starbucks latte sales! (Starbucks puts, perhaps?)

Also concerning is that the median sales price of existing homes sell 1.7% in August, which (as you know) was the first decline in 11 years. I’ve reported on this at length, as I feel it continues to spell doom for the homebuilder stocks. Don’t be fooled by pundits saying that we’ve hit bottom, because we’re nowhere close. Many of you have asked why I’ve chosen to zero in on St Joe (JOE – NYSE) as opposed to other homebuilder stocks like TOL, KBH, or BZH, and the reason is that JOE has all of their eggs in Florida’s real estate. And to be blunt, Florida’s real estate is in big-time trouble.

In fact, Barron’s says “the Florida housing market is due for a Category 5 hurricane.” Just look at these numbers: August existing home sales in Florida fell 34%. Condo sales fell 41%. And as I write, thousands upon thousands of homes that have been built on spec cannot command the original prices investors paid, which will severely cripple future land developments in Florida — paralyzing JOE’s future earnings potential. But for some reason, JOE continues to tick higher. Hmmm.

If that’s all the bad news facing the markets right now, let’s get back to the original question I posed above, which asks “How do we position ourselves to profit off the seemingly inevitable correction — yet still profit if the markets continue to rally?”

First, we get posited in a longer-term upside play on pharmaceutical stocks. Why pharma? Because they enjoy the largest negative correlation to housing starts. In other words, as housing activity declines, you can expect healthcare stocks to benefit the most (trading for just 1.3 times the market’s price to cash flow, pharma stocks enjoy the luxury of having earnings which are insulated from an economic downturn).

The best way to play the entire Pharma sector in one shot is via the Pharmaceutical HOLDRs (PPH – AMEX). With a diversified basket of companies like Abbott Labs, Briston Myers Squibb, Eli Lilly, Johnson & Johnson, Merck, Pfizer, Schering Plough, and Wyeth, you’re effectively getting positioned to ride the upside on this powerful group for the rest of the 2006 calendar year. Looking at the chart, you see a solid upside trend that looks to continue for at least the next two months. And if not, the PPH is a sector I’m comfortable adding to on any momentary dips.

PLAY: Buy the PPH November 75 Calls (PPH KO) at or under $3.90, good for the day. Current bid/ask spread is $3.60 to $3.80. Place a protective stop loss at $2.50.

Second, we continue to always have at least one upside position in a consumer staple. We’ve had great success playing General Mills (GIS – NYSE) and PepsiCo (PEP – NYSE), so let’s continue that successful theme using today’s candidate, Groupe Danone (DA — NYSE).

Acting as the overseas equivalent to General Mills, Groupe Danone offers fresh dairy, cereal, and packaged water products worldwide. Based in Paris, France they rank #1 in bottled water by volume thanks to Evian, the world’s best selling mineral water with 1.5 billion bottles sold every year in 5 continents and 125 countries. Chart-wise, DA’s recent dip under $30 offers us a nice opportunity to establish a longer-term upside position.

PLAY: Buy the DA January 30 Calls (DA AF) at or under $1.75, good for the day. Current bid/ask spread is $1.40 to $1.65. Place a protective stop loss at $0.90.

And finally, call me crazy, but I think it’s time to re-enter put options on Nike (NKE – NYSE). As you can see from the chart below, the stock has spent the entire month of September moving up at trajectory that simply cannot be sustainable. I’d like to play a move down that fills the upside gap right around the $84.00 level. Only this time around, I’m going to give us a little more time to witness the aforementioned downside move, which means we’ll own puts into November expiration.

PLAY: Buy the NKE November 90 Puts (NKE WR) at or under $3.50, good for the day. Current bid/ask spread is $3.20 to $3.40. Place a protective stop loss at $2.00.

I’m also keeping a close eye on the oil patch — as we could see quick lock-and-load trading opportunities in Marathon Oil (MRO – NYSE) and Transocean (RIG – NYSE). Also, a longer-dated call trade could emerge on Titanium Metals (TIE – NYSE) on any market breakdown, so stay tuned for these possibilities. Until then…

Lock and load!

Sincerely,