Addressing the “Spillover Effect”

What Names are Vulnerable?

By Bryan Bottarelli
Monday, March 19, 2007 10:22 AM EDT
Mon, 19 Mar 2007 14:22:00 GMT

Dear Bottarelli Research Member,

As we begin a new trading week with an opening-session gain on the Dow, let’s not forget some important technical events that occurred last week.

First off, the Dow just suffered its second-largest weekly drop of the year, closing down 166 points last week. But what’s even more worrisome is the magnitude of that fall. For example, it had taken the Dow 82 trading days from its first close above 12,000 to reach its February peak at 12,709 — but it took only 15 trading days to fall back below 12,000.

When you see such large amounts of market share lost in such a short period of time, you tend to see heightened levels of anxiety — which is why you’re hearing more and more about a “Spillover Effect.” In other words, will the housing and sub-prime downturn spread to the rest of the economy? And if so, what companies are next on the chopping block?

We’re already used the “Spillover Effect” to lock in a 41.18% gain on Lehman Brothers April 70 Puts (LES PN), as the market was nervous about the mortgage banker’s exposure to the sup-prime market leading up to their earnings announcement. As it turned out, LEH met earnings expectations (but did not beat them), which pushed the stock lower and handed us a nice gain. So, what other candidates could be Spillover plays? Here are some that have popped up on my short list:

KB Home (KBH – NYSE): With an earnings call scheduled for Thursday, March 22nd at 11:00 am Eastern, investors will be wondering if the tightening credit spread will hit KBH the hardest. After all, KBH has the highest exposure to the first time home buyer — as the median price of their homes is $277,000 compared to $690,000 for high-end homebuilder Toll Brothers (TOL – NYSE). Similar to how high-end retailers like Nordstrom (JWN — NYSE) can survive recessions while low-end retailers like Wal-Mart (WMT – NYSE) feel a big time pinch during this same period, we could see a situation forming up if KB Homes forecasts a difficult year ahead. In fact, a weak announcement on Thursday could easily push shares from $45.50 down to $42.00 rather quickly.

KBH

Countrywide Financial (CFC – NYSE): CFC came up on my scan thanks to insider sales which reached a 5-year peak. From what I can tell, CFC’s 42% loan exposure to ARMs signals that the company can withstand a difficult market environment — but certainly not prosper — if mortgage credit runs dry. This is not a strong catalyst for continued upside momentum — which supports holding downside puts on CFC. The shares are weak, as you can see, but a re-test of the $33 low could be in the cards.

CFC

Weyerhaeuser (WY – NYSE): We’re also seeing heavy selling in WY. According to recent insider transaction filings, a total of 12 insiders have just sold 755,997 shares of WY worth over $63 million dollars. As you can see, WY has been in a tremendous upside run — but the stock is right now testing the critical level at the 50-day moving average. If this level cannot hold (as WY insiders seem to expect) we could see noticeable weakness without any major support levels for quite some time.

WY

Let’s keep an eye on all three of these “Spillover Effect” candidates for potential put play opportunities. It may also be a smart idea to add another protective put play on the DIA, as the recent market reversals have come rather abruptly on an intra-day basis. For now, let’s see how the trading day progresses. The moment it’s time to move, you’ll be the first to know. Until then…

Lock and load!

Sincerely,

Bryan Bottarelli

Bryan Bottarelli
Editor, Bottarelli Research

© 2012 CSR Group, LLC. All rights reserved. Published in USA.

Information, opinion, research, and commentary contained herein is obtained from sources believed to be reliable; their reliability, however, cannot be guaranteed. The maxim of Caveat Emptor applies — let the buyer beware. Bottarelli Research does not provide individual investment advice, act as an investment advisor, or individually advocate the purchase or sale of any security or investment.

Investments recommended in this service should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Bottarelli Research reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscriber’s initials will be used unless express written permission has been granted to the contrary.

CSR Group, LLC expressly forbids its writers from having a financial interest in any security recommended to readers. Furthermore, all employees and agents of CSR Group, LLC and its affiliate companies must wait 24 hours before following a published recommendation.

Bottarelli Research alerts contain time-sensitive information, and are published and distributed to members with urgency. Because of this, not all published materials can be adequately proofread, and an occasional spelling or grammar error may exist.


Other Options Alerts From March 2007