Joe Kunkle, The Investment U Research Team

One of the greatest assets you can have as a trader or investor is having the ability to spot trends, and use that information to draw conclusions about what will occur in the future.

I have long used the options market as a way of watching where the “smart money” is making bets. It has allowed me to foresee the collapse of financial stocks and the re-emergence of oil and commodity related stocks.

And from the signals I’m seeing, we may be on the verge of another big move.

Over the past few weeks, large volume bullish option trades have been indicating the expectation for a major recovery in heavy machinery stocks for the third quarter of 2009.

But we can’t really understand the significance of these trades without looking at the big picture first.

Industrial SPDR (NYSE: XLI) stocks have a very high correlation with the broader markets – it’s why they call it the Dow Jones Industrial Average – and to even a large extent, the economy. You can simply look at a chart of the XLI versus the S&P 500 (.INX) for confirmation.

But it’s more than visual similarity, its fundamental.

Economic data such as GDP growth, ISM Manufacturing Index, Industrial Production, and Capacity Utilization are all industrial based figures that give us clues to where the economy is heading. And although we are still seeing weak economic numbers, all signs are pointing to recovering indicators.

Heavy machinery is an integral aspect to increased economic production. These are the machines that will pump more fuel, dig more minerals, refine more metals and ultimately produce the materials that we make everything else from.

There has been lots of talk about inflation recently. And it’s not hard to see why. Historically, when nations printed lots of new money – like they are now – inflation has occurred.

The anticipation of inflation has sent commodity stocks soaring. And as a result, the heavy machinery companies, which make the products to bring gold, oil, silver, copper, and agricultural soft commodities out of the ground, have become very interesting.

Following the Smart Money in Heavy Machinery

One of the first bullish large dollar bets came on May 20 in a lesser know company, Illinois Tool Works (NYSE: ITW), a diversified machinery company that makes products ranging from construction tools to ventilation systems in kitchens.

The trader used a ratio call spread, a strategy bearish on volatility and in this case bullish on price, to buy 2,000 September $30 calls and sell 6,000 September $40 calls.