It was a Fed day classic. Punters buy, buy, buy just before and immediately after the release of the FOMC policy statement, hoping for some kind of surprise (or surprise reaction) that will spark a rally. Then when the smoke clears to reveal that nothing at all has changed - except that the market is still overbought - buyers disappear like ghosts, and Kenny Rogers knows when to run. Lessons to be learned? You bet.

If you just can’t help yourself and simply have to play the Fed trade, remember:

• Whatever happens in the few minutes after the statement comes out is usually just noise. You might be able to profit from it, but you have to be a fast trader.
• Don’t trust the initial reaction. Once traders make up their minds about which way the market is going to move, they’re as likely to be wrong about the longer-term direction as they are to be right. As we saw today, the reaction offered a nice chance to bag a profit with puts on SPY or QQQQ - but it probably isn’t a good idea to hold the bulk of your position overnight.

Bottom line: It takes at least a day or two for the market to digest any Fed monetary-policy statement, especially in the current highly charged atmosphere of tension between inflation and recession-plus-liquidity-squeeze. By Friday, we might have a chance of knowing where the market really is headed post-Fed.

A look at the chart to the right - which shows the relationship between Target and Wal-Mart stock - tells a rather interesting story about consumer spending. As the economic recovery in 2003 ensued Targets stock lifted while Wal-Mart stock actually drifted lower. However since the credit crunch showed up on the economic radar Targets stock took a tumble and Wal-Mart stock has caught a bid. Why the disparity? Is it just because Wal-Mart has suffered from bad PR over the years and maybe now folks have finally forgotten about all that?

The Thesis:

While Target and Wal-Mart seem to be very similar - both being big box discount retailers that sell similar products - they have a rather striking difference:

The average Wal-Mart customer earns $35,000 a year, compared with $50,000 at Target and $74,000 at Costco.” [Sebastian Mallaby, Washington Post, “Progressive Wal-Mart. Really,” 11/28/05]

This income difference and the price action in the chart is indicative - and probably obvious to most us who have shopped there - that Wal-Mart sells inferior goods. Inferior goods typically demonstrate a negative income elasticity of demand, which is just fancy economist talk that demand for inferior goods decline as incomes rise. While incomes were rising Wal-Mart suffered as shoppers migrated to the more superior products of Target. But now that the credit crunch has arrived and the economy is weakening consumers are migrating back to the inferior goods of Wal-mart. Keep an eye on these two retailers moving forward as they should tell the story of how the average consumer is doing. In addition this relationship provides a nice pairs trade.

The Trade:

There are several different ways you could play this from a simple long WMT stock and short TGT stock to long WMT and short XLY or RTH. If you want to play this with some options TGT and WMT are in different cycles so you would have to play with JAN 09 LEAPS. If you don’t want to go out that long you can play the September options in XLY and WMT. Stick with At the money strikes on whatever pair you choose. Wal-Mart reports first quarter earnings May 13 so some extra caution may be necessary. Some extra premium is likely bid up in the options which exposes you to extra risk from volatility dropping after earnings. Wal-Mart may report great earnings but it could already be baked in the cake.

As always with bonus trades please exercise discretion and remember that these are for educational and entertainment purposes.

If you’re not already in a pretty delta-neutral place, think about balancing things out tomorrow ahead of the 2:15 fireworks. We closed out one of our newsletter positions today for a small loss so that we can ride through the rest of May expiration with less risk and little concern about the magnitude of any market reactions.

We won’t do the reversal readings tonight, suffice to say that (with the exception of the QQQQs) the indexes have worked off their previous short-term overbought conditions, relieving the pressure by way of time rather than price. Still, if you have a bullish perspective there remain some points of concern. VIX and More has some great material on possible market complacency here, while the Ticker Sense folks remark that when the indexes and so many major sectors are sitting right at or above the tops of their trading envelopes, it might pay to be cautious.

This week should be pretty volatile, with plenty of government data, earnings announcements, and Fed action to push markets to and fro. Many traders are paying special attention to the GDP announcement Wednesday morning and the FOMC news later that afternoon. As is our wont, we advise taking off some risk ahead of Fed meetings.

Markets were very quiet until the last forty-five minutes today, trading on very light volume, and the S&P 500 emini futures weren’t able to break above the 1404 level. Some higher volume selling pushed the Dow and the SPX into negative territory into the close.

Citigroup must have updated the methodology for their panic/euphoria model, as cited regularly in Barron’s. We know this because - as you can see from the chart at left - even at the absolute peak of exuberance back in October 2007, the model gave an official reading of “0″, meaning sentiment was neither euphoric nor panicked. Those of us who were alive and trading during those halcyon days might remember things somewhat differently.

In any case, that same panic/euphoria model registered a reading above 0.3 over the weekend, which must be the highest on record, and only makes sense if you assume that some new methodology has been put in place. We’ll reset our expectations about this metric, and see whether it provides any useful indications going forward.

Speaking of Citigroup: David Gaffen at the WSJ MarketBeat blog has a good piece on why the rally in banking stocks may have overextended itself.

Reversal Readings

Overbought readings persist.

SPY & IWM - above 97
XLV - Health care - 98
XLF - Financials - 95
EWA - Australia - 9
IYR - Real estate - 98
IBB - Biotech - 97
XLI - Industrial - 96
XLY - Consumer discretionary - 96
PHO - Water - 98
IYT - Transports - 98
EWW - Mexico - 1.71

Whew! The imminent financial-system collapse, which some had feared after the Bear Stearns meltdown, didn’t come to pass, and first-quarter earnings haven’t been all that bad. But the buyers climbing over each other Friday afternoon to make sure they don’t miss getting in on the big recovery evidently weren’t watching CNBC before the market opened that morning (ordinarily, we wouldn’t blame them), when veteran economist Joseph Stiglitz reminded us that the credit crisis did more damage to the financial system than can be undone in just a few months.

Maybe it’s not the kind of news the media thinks people want to hear right now, because even the sensational headline that CNBC.com chose for its summary of Stiglitz’s comments doesn’t seem to have spurred much circulation outside the blogosphere. And yes, we know that you don’t want to hear “one of the worst economic downturns since the Great Depression” either; we don’t like people losing their houses and their jobs any more than you do. But we also think it’s important to appreciate the fact that big risks still remain in the economy, and thus in the market - despite implied volatility levels that are heading back into “all clear” territory.

Stiglitz, once Chairman of the President’s Council of Economic Advisers and later Chief Economist for the World Bank, explained why he thinks, “in some ways, this is the worst recession we’ve had in a long time,” as follows:

Most of the other economic downturns [since the 1930s] have been one of two sorts. One of them is inventory accumulation. There’s a slight slowdown, firms get rid of their excess inventories, and the economy just picks up where it left off. The other one is, inflation [builds] and the Fed steps on the brakes a little too hard. It realizes that it stepped on the brakes too hard, and it takes its foot off the brakes and then puts it gently on the accelerator, and the economy takes off again.

This time is a little bit different, because, at the center of the economy are the financial institutions, and they’ve been very badly impaired. It’s not just like excess inventories; it’s not like the Fed has stepped on the brakes too hard. [The Fed] could put its foot on the accelerator, but [this time] the banks aren’t going to be lending. The impairments to their balance sheets are severe.

In response to a viewer question about small business, Stiglitz elaborated on how weakness in finance is likely to spread into the general economy:

Small businesses are really the source of job creation in the economy, and a lot of the innovation. They depend very heavily on banks, and that’s where I get very worried. As we see the financial system going into a squeeze, the people who are really going to be hurt are the small businesses. The big companies, they can borrow in Europe, they can borrow anywhere there’s liquidity, but these [small businesses] are the companies that are really going to suffer.

Add in the slowdown in spending caused by consumers’ inability to continue funding their purchases with home-equity credit, and you have a scenario in which, Stiglitz says, the President’s economic stimulus package is “a drop in the bucket” that will disappear into a black hole of sub-prime losses and an unavoidable increase in net personal savings.

Okay, so there’s nothing here we haven’t heard before, and it’s no surprise that media fatigue has set in. We get it. We also get that it would be dangerous to let complacency cause us to forget how little really has changed since the credit contraction began to unfold and brought stock prices down initially to the levels they’re rallying close to once again.

That said, there’s no question that the short-term bias has been to the upside, and it looks like the bulls might not be satisfied (and bears won’t feel safe to start shorting again) until there’s a serious battle around the downtrend-resistance and 200-day moving-average lines on the charts of the major indexes. What’s more, the rally conceivably could continue, no matter what the state of the real-world economy may be: markets can remain irrational and overbought (or oversold) long enough to cause serious damage to a portfolio that’s biased in the wrong direction. This is why we concentrate on strategies that are essentially non-directional, and balance our monthly positions with a variety of trades that spread out the directional risk.