2 Pairs Trades To Avoid A Market Correction
#-ad_banner-#Over the past few months, the S&P 500 has traded in a narrow 80-point range, and a familiar refrain is again making the rounds: “Sell in May and go away.” That axiom highlights the seasonal underperformance that the summer months often bring.
The market’s detractors are pointing to the weakest earnings expectations since the recession and calling for a correction or even a full-blown bear market.
The force of the herd may send stocks down marginally over the next few months, but several stronger forces are lining up to make this another positive year for investors.
I’ve found one way to hedge against a market correction, while still benefiting from higher prices through the end of the year.
Here Come The Perma-Bears
A surging dollar and plummeting oil prices are setting the market up for one of the worst earnings seasons since the recession. Earnings for companies in the S&P 500 are expected to drop by 4.6% in the first quarter compared to the same period last year. Expectations for earnings have fallen by more than 8% since the end of the fourth quarter, the largest decline in estimates since the first quarter of 2009.
The glum earnings outlook and fear of an eventual interest rate hike by the Federal Reserve are being used by the perma-bears as the latest argument for a correction in stock prices. Noted market technician Ralph Acampora told CNBC last week that a “stealth correction” is already underway and we could be in for a 10% drop.
But we’ve been here before and calls for double-digit corrections in recent years have failed to come true. Such predictions usually arise when the market rally has paused. Invariably, the market has gone on to ascend new heights, and I look for more of the same this time around.
Fundamentals Point Higher For The Bulls
Even against the fear of Federal Reserve tightening, interest rates are likely to remain very low in the United States. Meanwhile, the rest of the world is still in full-blown monetary easing mode. The European Central Bank still has 18 months and more than $1 trillion to pump into its financial system, and Japan’s Central Bank recently decided to continue its own easing.
While the halving in energy prices has driven expectations for a 64% decrease in energy sector earnings in the first quarter (against the same period last year), sectors with heavy energy demands have already started to benefit. Earnings at industrial firms are seen rising more than 5% in the first quarter, and the iShares Transportation Average ETF (NYSE: IYT) is outperforming the S&P 500 over the past 12 months.
Don’t deny the power of cold, hard cash. Companies in the S&P 500 (ex-Financials) had a record $1.43 trillion in cash and marketable securities at the end of last year. That factor continues to boost earnings per share through massive buyback programs.
Caught in this conflicting environment of potential near-term weakness and longer-term gains, investors may want to use a long-short hedging strategy for protection. Stocks with high betas and weak outlooks can be shorted and paired against your long positions.
If the market does move lower, these high-beta names should fall faster. The profit from the short position can help offset losses on the long positions.
Google, Inc. (Nasdaq: GOOG) has lagged the market over the past year and now trades for 27 times trailing earnings. That might seem expensive until you consider the company is still booking nearly 19% sales growth.
Google dominates the internet advertising market, which is still relatively underutilized, but growing steadily. Google’s 60% market share in global search makes it ubiquitous and a stable cash machine. The company’s beta of 1.06 is only slightly higher than the general market.
Paired against that bullish trade: CoreLogic, Inc. (NYSE: CLGX), a $3.2 billion real estate information services provider could make a good short sale candidate. The company’s sales are heavily leveraged to the mortgage market and could suffer when rates increase.
Refinancing volume has been strong as homeowners take advantage of low rates, but mortgage originations have been slow to recover. Shares trade for 36.6 times trailing earnings, even though sales have been flat for several years and are expected to grow just 6% this year. Besides being volatile around housing-related news, the shares carry a beta of 1.48.
Also on the long end of a pairs trade: Amgen, Inc. (Nasdaq: AMGN), a $125 billion (in market value) biotech behemoth that just received approval by the European Commission for Vectibix, a first-line treatment for colorectal cancer.
The shift to a royalty-based arrangement from profit-sharing on Enbrel, a key, top-selling drug, and plans to cut 20% of staff through this year, should lead to significant margin improvement. Shares trade for 24 times trailing earnings, but are relatively stable with a beta of just 0.6.
By comparison, BioCryst Pharmaceuticals, Inc. (Nasdaq: BCRX) is both richly-valued and volatile. Revenue is extremely choppy, down 18% in the 2014 against the prior year and it’s expected to rise by 20% over the next four quarters.
Even on higher sales, the company remains unprofitable, on pace to lose more than $1 a share in 2015. As sales have deteriorated over the last few years, the share count has surged on options to management and financing. Shares outstanding have jumped 48% since 2011 to 67 million shares. The stock trades with a beta of 4.2 and could see significant weakness on a market selloff.
Risks To Consider: Higher beta stocks may outperform larger, low-beta names if the market continues higher without a correction. Investors should limit hedging positions to a small percentage of their total portfolio.
Action To Take –> Hedge your stock positions against a near-term market correction with these two pairs trades.
This strategy is so successful that StreetAuthority dedicated an entire newsletter to the concept. Trader’s Edge uses a system of going long three fundamentally sound companies and going short three companies primed to drop. This has allowed us to capitalize on market trends no matter which way the market moves — we even completely avoided the effects of the Great Recession. To learn more about this system, click here.