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Risks Remain As The Market Makes A New High

Although the S&P 500 made another all-time high on Monday, closing fractionally above 1,593, risks of a near-term correction remain. In his Global Investment Outlook for May, Dr. John Praveen of Prudential International Investment Advisors warned that "stocks face increased risk of a healthy, overdue correction." Dr. Praveen laid out five possible triggers for a near-term correction:

1) U.S. GDP growth on track to a sharp slowdown in Q2 after the strong Q1 rebound; 2) Eurozone recession continues in H1; growth disappointment in China; 3) Continued Italian post-election uncertainty and Cyprus crisis not yet resolved; 4) Risk of Q1 earnings disappointment; and 5) Uncertainty about Fed's QE exit strategy.

As I mentioned in a recent article ("Risky Stocks In A Complacent Market"), I've been scanning for stocks that may be at greater risk during the next correction. In this post, I'll highlight several large cap stocks that a leading quantitative analysis firm currently predicts will substantially underperform the market.

Predicting Market Underperformance

In a previous post, we noted that the quantitative forensic accounting analysis firm GovernanceMetrics International (GMI) had given dozens of mid cap stocks the worst of the five possible ratings on GMI's AGR (Accounting And Governance Risk) Equity Risk Factor, indicating that the companies were liable to "substantially underperform" the market. According to GMI, companies given its worst-possible Equity Risk Factor ranking have, as a group, substantially underperformed the market. At the time, there were only a handful of large cap stocks to which GMI had given its worst-possible Equity Risk Factor ranking. As of Monday though, GMI had given this ranking to more than two dozen large cap stocks. In this article we'll look at 5 of the most actively-traded of those large caps predicted to "substantially underperform" the market.

High Accounting And Governance Risk

Of the more than two dozen large cap stocks predicted by GMI to substantially underperform the market, these five were among the most-actively traded: Cisco Systems (NASDAQ:CSCO), Apple (NASDAQ:AAPL), Ford (NYSE:F), Wells Fargo (NYSE:WFC), and JPMorgan Chase (NYSE:JPM). Knowing that the AGR Equity Risk Factor is derived from another GMI Metric, the Accounting And Governance Risk Rating, I reviewed GMI's Accounting And Governance Risk Review report on these five stocks (via Fidelity), and saw that GMI gave its worst possible ranking, "Very Aggressive", to each of the five stocks, indicating that they had higher accounting and governance risk than more than 90% of the stocks GMI covers. According to GMI, companies rated "Very Aggressive" are 10 times more likely to face SEC enforcement actions than those rated "Conservative" (the best of its four possible Accounting And Governance Risk ratings).

Ameliorating The Risk Of Owning These Stocks

For investors in these companies, who are wary of the risks of holding them but would rather not sell their shares at this point, we'll look at a couple of different ways they can hedge against significant declines over the next several months. To illustrate, we'll use one of these companies, Apple, as an example. Then we'll show the costs of hedging the other stocks we've discussed here in the same manner.

Two Ways Of Hedging Apple

Hedging AAPL proved prudent last year, as we noted in a post a few months ago. Below are two ways an Apple shareholder could have hedged 1000 shares against a greater-than-20% drop over the next several months, as of Monday's close.

1) The first way uses optimal puts*; this way allows uncapped upside, but has a cost. These were the optimal puts, as of Monday's close, for an investor looking to hedge 1000 shares of AAPL against a greater-than-20% drop between then and October 18th.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 1.66%.

2) An AAPL investor interested in hedging against the same, greater-than-20% decline between Monday's close and mid October, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar was negative, meaning the Apple investor would have gotten paid to hedge in this case.

Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar. In practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

Hedging Costs For All Of The Names Mentioned Above

The table below shows the costs, as of Monday's close, of hedging all of the stocks mentioned above in a similar manner as AAPL: first, with optimal puts against a >20% drop over the next several months; then, with optimal collars against the same percentage drop over the same time frame, while capping the potential upside at 20%. The SPDR S&P 500 ETF (NYSEARCA:SPY) was added to the table for comparison purposes.

Name

Symbol

Optimal Put Hedging Cost

Optimal Collar Hedging Cost

Cisco Systems

CSCO

2.14%

1.00%

Apple, Inc.

AAPL

1.66%

-0.03%

Ford

F

2.42%

2.05%

Wells Fargo

WFC

1.08%

1.00%

JPMorgan

JPM

0.98%

0.86%

SPDR S&P 500

SPY

0.44%

0.43%

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

Disclosure: I purchased optimal puts on SPY as a hedge against market risk. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Large Caps That May Fare Worse During A Coming Correction