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Another Reason For Caution As The Market Climbs

In a previous article, I mentioned portfolio manager John Hussman's warning in his most recent market commentary that stocks continue to be "overvalued" and "overbought", despite the recent, weakening economic data. On Twitter on Thursday, value investor Tobias Carlisle highlighted an example of that weakening economic data, the deterioration in the reported earnings of S&P 500 stocks:

Earnings continue to roll over. MT @paragoncap: 69% of $SPX reported EPS. On pace for $25.15 vs $26.20 Est = 4% miss: twitter.com/ParagonCap/sta…

- Tobias Carlisle (@Greenbackd) May 2, 2013

Apparently unfazed by the weakening earnings, investors drove the S&P 500 to a fractional gain on Thursday.

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 forensic accounting research firm GMI Ratings. In this post, we'll look at several stocks rated "sell" by another research firm, Jefferson Research. To appreciate its sell ratings, it's helpful to understand how Jefferson comes up with them.

The Jefferson Research Process

Like GMI Ratings, Jefferson Research's methodology includes a focus on forensic accounting. Jefferson Research's thought process here is that when companies can't meet their growth guidance, they often attempt to disguise that failure through more aggressive accounting. Because of that, the Jefferson Research team argues that the right analytical approach involves both measuring fundamental metrics as well as potential distortions in the financial reporting.

Jefferson synthesizes information on about fifty variables to make its buy, hold, and sell ratings, analyzing companies on both fundamental performance and financial reporting forensics. Key areas of focus include:

  • Earnings Quality
  • Cash Flow Quality
  • Operating Efficiency
  • Balance Sheet Quality
  • Valuation

Screening For Sell-Rated Jefferson Research Stocks

Using Fidelity's screener, I scanned for stocks that were rated "sell" by Jefferson Research 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 Jefferson Research on Thursday were:

  • Kodiak Oil & Gas (KOG)
  • Arch Coal, Inc. (ACI)
  • J.C. Penney (JCP)
  • Chesapeake Energy (CHK)
  • Atmel Corporation (ATML)

Readers may recall that J.C. Penney also appeared in a previous article, in which we looked at stocks rated "sell" by another research firm, Verus Analytics; it shouldn't be surprising that there would be some overlap in the ratings generated by different research firms that both use quantitative, fundamental approaches. Seeking Alpha contributor Quoth The Raven also remains bearish on the stock.

The prevalence of energy companies coming up on the Jefferson Research screen is notable though -- in addition to the three listed above, more than half of the less widely-traded stocks that came up on this screen were also energy companies. Of the energy stocks listed above, two, Kodiak Oil & Gas and Chesapeake Energy, released earnings this week; Kodiak missed its adjusted earnings estimates, and Chesapeake beat its adjusted earnings estimates. Atmel Corporation, the lone tech stock listed above, also released earnings this week and beat its adjusted earnings estimates.

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, Chesapeake Energy, 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 Chesapeake Energy

Below are two ways a Chesapeake Energy shareholder could have hedged 1000 shares against a greater-than-20% drop over the next several months, as of Thursday's close.

1) The first way uses optimal puts*; this way allows uncapped upside, but has a higher cost. These were the optimal puts, as of Thursday's close, for an investor looking to hedge 1000 shares of CHK 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 5.22%.

2) A CHK investor interested in hedging against the same, greater-than-20% decline between Thursday'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 0.73%.

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 (CLF) earlier this year.

Hedging Costs For All Of The Names Mentioned Above

The table below shows the costs, as of Thursday's close, of hedging all of the stocks mentioned above in a similar manner as CHK: 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.

Name

Symbol

Optimal Put Hedging Cost

Optimal Collar Hedging Cost

Kodiak Oil & Gas

KOG

10.6%

7.28%

Arch Coal, Inc.

ACI

19.9%

0.82%

J.C. Penney

JCP

15.2%

1.85%

Chesapeake En.

CHK

5.22%

0.73%

Atmel Corp.

ATML

12.1%

8.87%

SPDR S&P 500

SPY

0.96%

0.91%

*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.

Source: Risky Stocks In A Rising Market

Additional disclosure: I purchased optimal puts on SPY as a hedge against a market correction.