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The Disconnect Continues

A day after Friday's stock rally, which saw the Dow Jones Industrial Average briefly break the 15,000 barrier intraday, John Authers highlighted the current disconnect between the stock market and the real economy, Friday's positive U.S. jobs numbers notwithstanding ("Central bankspeak, not results, is driving stocks"):

The world economy may not have fallen into a second Great Depression but it remains in poor health. Europe is in the doldrums, China's fast growth is slowing, and growth in the US is bland.

Authers pointed out that there were two ways for this disconnect to resolve itself: either rising share prices will "spark the economy back into life", or a continually weak economy will drag share prices down.

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" (and "strong sell", in this case) by another research firm, Ford Equity Research. To appreciate its sell ratings, it's helpful to understand how Ford Equity Research comes up with them.

The Ford Equity Research Process

Ford Equity Research uses a proprietary, quantitative model to analyze its universe of 4,000 stocks based on three main criteria:

  • Earnings strength
  • Relative valuation
  • Price movement

Ford calculates earnings strength based on a weighted combination of factors including its own earnings momentum model, earnings surprises, and recent changes in analyst earnings estimates. Relative valuation is determined in order of their trailing twelve months operating earnings yield (operating earnings per share divided by share price). Ford evaluates price movement over the prior one month, one quarter, and one year periods; it views price appreciation over the trailing one year period positively, but rapid price appreciation over the past month or quarter can raise concerns that a stock is overbought.

Unlike some other independent research firms that use three different ratings (buy, hold, sell), Ford uses five (strong buy, buy, hold, sell, strong sell).

Screening For Sell-Rated Ford Equity Research Stocks

Using Fidelity's screener, I scanned for stocks that were rated "sell" or "strong sell" by Ford Equity 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" or "strong sell" by Ford Equity Research on Friday were:

  • Advanced Micro Devices (NYSE:AMD)
  • Arch Coal, Inc. (NYSE:ACI)
  • J.C. Penney (NYSE:JCP)
  • Zynga (NASDAQ:ZNGA)
  • Weatherford International (NYSE:WFT)
  • SuperValu (NYSE:SVU)

Of the stocks above, Arch coal and J.C. Penney were rated "strong sells", and the others were rated "sell". J.C. Penney and Arch Coal may be familiar names to readers: Both companies were rated "sell" by Jefferson Research, as we noted in this article, and J.C. Penney was rated "sell" by Verus Analytics as well, as we showed in a previous article. As I've mentioned before, it shouldn't be surprising that there would be some overlap in the ratings generated by different research firms that both primarily use fundamental approaches.

Regarding the other stocks listed above, shares of Advanced Micro Devices had their best week in a decade last quarter, on hopes that its chips would see increased demand from manufacturers of next generation video game consoles. Zynga has been dogged by declining active users and revenues. Seeking Alpha contributor Fundamental Analyst cites these declines as reasons to sell the stock; Seeking Alpha contributor George Kesarios argues that Zynga's future will depend on its ability to successfully transition into gaming. Shares of Weatherford International rose on Friday, buoyed by the company's Q1 results, and positive guidance from management. SuperValu has been restructuring, selling subsidiaries and laying off workers; the company noted severance for those workers impacted its fiscal fourth quarter results.

Drilling Down On The Ratings

To get a sense of why Ford Equity Research was bearish on these stocks, I reviewed its research reports for each of them. Ford judged the earnings strength of Advanced Micro Devices as "very positive", noting that the firm had shown a strong acceleration quarterly earnings growth. AMD apparently earned its sell rating from Ford because of the "very negative" assessment it earned on the other two major components in Ford's analysis, price movement and relative valuation. On price movement, AMD exhibited strong monthly and quarterly performance combined with weak performance over the trailing one year period -- this is the opposite of the pattern Ford prefers. On relative valuation, AMD's operating earnings yield placed it in the bottom 11th percentile of the companies Ford rates.

Arch Coal received a "very negative" assessment on both its earnings strength and relative valuation; its earnings yield ranked it in the bottom 14th percentile of the firms in Ford's universe. It received a "negative" assessment on price movement for a similar reason as AMD, positive one month performance paired with weak one year performance.

Ford gave "very negative" assessments to J.C. Penney on all three of its main criteria: earnings strength, relative valuation, and price performance. On relative valuation, J.C. Penney's operating earnings yield ranked it in the bottom 8th percentile of the firms in Ford's research universe.

Zynga earned a "positive" assessment from Ford Equity Research on its earnings strength, but a "negative" assessment on its relative valuation and a "very negative" assessment on its price movement. On relative valuation, Zynga's operating earnings yield placed it in the 21st percentile of the firms Ford covers.

Like Zynga, Weatherford International earned a "positive" assessment on its earnings strength, but "negative" and "very negative" assessments on its relative valuation and price movement, respectively. On relative valuation, Weatherford International's operating earnings yield placed it in the 38th percentile in Ford's research universe.

SuperValu also earned a "positive" assessment on its earnings strength, but "negative" and "very negative" assessments on its relative valuation and price movement, respectively. The positive earnings strength is a little surprising here, but Ford's research report notes that analyst estimates for SVU have recently been raised, so that may be the key factor here. On relative valuation, Supervalu's operating earnings yield placed it in the 26th percentile in Ford's research universe.

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, Weatherford International, 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 Weatherford International

Below are two ways a Weatherford International shareholder could have hedged 1000 shares against a greater-than-20% drop over the next several months, as of Friday'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 Friday's close, for an investor looking to hedge 1000 shares of WFT against a greater-than-20% drop between then and November 15th.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 5.15%.

2) A WFT investor interested in hedging against the same, greater-than-20% decline between Friday's close and mid November, 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 0.44%.

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 the SPDR Gold Trust ETF (NYSEARCA:GLD).

Hedging Costs For All Of The Names Mentioned Above

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

There were no optimal puts for Zynga or J.C. Penney given these parameters on Friday, because the costs of hedging them against greater-than-20% drops were greater than 20% of position value in both cases. The cost of hedging Zynga with an optimal collar using the parameters above was negative, meaning an investor would have gotten paid to hedge in this case.

Name

Symbol

Optimal Put Hedging Cost

Optimal Collar Hedging Cost

AMD

AMD

14.7%

1.11%

Arch Coal, Inc.

ACI

16.9%

11.0%

J.C. Penney JCP NA 18.0%

Zynga

ZNGA

NA

-2.80%

Weatherford Int.

WFT

5.15%

0.44%

SuperValu Inc.

SVU

3.35%

3.11%

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: Stocks That May Fare Worse In The Next Correction