Climbing A Wall Of Worry
The S&P 500 ended the month of April at another new high, closing at 1597.57 on Tuesday. Tuesday's record close came a day after fund manager John Hussman warned in his latest weekly market commentary ("When Rich Valuations Meet Poor Economic Data") that stocks continue to be "overvalued" and "overbought", despite the recent, weakening economic data. The market continues to climb a wall of worry.
Searching For Risky Stocks In A Rising Market
As the market has climbed higher I've continued my search for stocks that might be at greater risk during the next correction. To avoid bias, I've used fundamental screens, such as stocks overvalued on PEG (price/earnings/growth) basis, and stocks predicted to substantially underperform the market by independent research firm GovernmentMetrics International. In this post, we'll look at several stocks rated "sell" by another research firm, Verus Analytics. To appreciate its sell ratings, it's useful to understand how Verus comes up with them.
The Verus Analytics Research Process
Verus Analytics provides opinions (buy, sell, or hold) which are included on Thomson/Reuters research reports. Verus's opinions are based on an empirically-derived and historically back-tested stock rating system. To develop a rating, the quantitative system analyzes several factors, including:
- Earnings quality
- Balance sheet
- Income statement
- Insider transactions
Verus takes all of these factors into account, and performs its own valuation analysis before issuing a buy, hold or sell rating on the roughly 6,000 US stocks it covers.
Screening For Sell-Rated Verus Analytics Stocks
Using Fidelity's screener, I scanned for stocks that were rated "sell" by Verus Analytics and had market capitalizations below 20 billion (in order to spotlight some stocks that may not be as widely covered as mega caps.). Among the most widely-traded stocks in this range that were rated "sell" by Verus Analytics on Tuesday were:
- Barrick Gold Corp. (ABX)
- Riverbed Technology (RVBD)
- J.C. Penney (JCP)
- MGM Resorts International (MGM)
- Cliffs Natural Resources, Inc. (CLF)
Readers may recall that Barrick Gold Corp. also appeared in this recent article, in which we looked at stocks rated "sell" by another research firm, Zacks; it shouldn't surprising that there would be some overlap in the ratings generated by different research firms that both use quantitative, fundamental approaches. It's also unsurprising to see a couple of the other names on this list. Riverbed Technologies just posted its second quarterly earnings miss in a row, as Seeking Alpha contributor Nikos Theodosopolous elaborated on recently. J.C. Penney fired its CEO last month, and was recently downgraded by Moody's.
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, Barrick Gold, 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 Barrick Gold
Below are two ways an Barrick Gold shareholder could have hedged 1000 shares against a greater-than-20% drop over the next several months, as of Tuesday'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 Tuesday's close, for an investor looking to hedge 1000 shares of ABX 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 6.09%.
2) An ABX investor interested in hedging against the same, greater-than-20% decline between Tuesday'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, as a percentage of position value, was 0.05%.
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).
Possibly More Protection Than Promised
In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this Instablog post about hedging shares of Cliffs Natural Resources earlier this year.
Hedging Costs For All Of The Names Mentioned Above
The table below shows the costs, as of Tuesday's close, of hedging all of the stocks mentioned above in a similar manner as ABX: 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 (SPY) was added to the table for comparison purposes.
Optimal Put Hedging Cost
Optimal Collar Hedging Cost
SPDR S&P 500
*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.
Additional disclosure: I purchased optimal puts on SPY as a hedge against a market correction.