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A Reminder About The Limitations Of Central Bank Policy

In a sign of continued market complacency in the US, the S&P 500 Volatility Index (VIX) closed below 15 on Thursday, shrugging off the troubling market action in Japan over the past week. If the recent stock slide in Japan, which has occurred during a period of massive quantitative easing by its central bank, weren't enough of a reminder that stocks can still decline during periods of central bank easing, portfolio manager John Hussman offered another reminder via Twitter on Thursday:

To observe that the past two 50% market plunges were accompanied by aggressive, continuous Fed easing isn't cherry-picking. It's a warning.

- John P. Hussman (@hussmanjp) May 30, 2013

Searching For Risky Stocks In An Expensive Market

As the market has climbed higher, I've continued my search for stocks that might be at greater risk during the next significant correction. To avoid bias, I've used fundamental screens, such as stocks overvalued on a 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 / most unfavorable" by Market Edge. To appreciate its ratings, it's helpful to understand Market Edge's approach to security analysis.

The Market Edge Research Process

Market Edge is a product of Computrade Systems, Inc., a privately-held company based in Atlanta that provides investment research to institutions, stockbrokers and private investors. Market Edge is a quantitative system that evaluates stocks according to five main criteria:

  • Valuation. Market Edge takes into account traditional valuation metrics such as Price/Book Value, Price/Cash Flow, Price/Sales, along with its Market Edge Price/Earnings/Growth (PEG) ratio, which uses Market Edge's forward earnings estimate and estimated growth rate.
  • Profitability. Market Edge uses operating cash flow as the key metric here.
  • Balance Sheet Strength. The key ratio used here is the current ratio (short term assets divided by short term debts).
  • Growth Potential. Here, Market Edge looks at trailing earnings per share ((NYSEARCA:EPS)) trends.
  • Analyst Consensus Forecast: Market Edge compares analyst estimates for the next two quarters with the company's earnings per share in the most recent quarter.

Based on these five criteria, Market Edge assigns a buy, hold or sell ratings to each stock in its 4,000+ stock universe.

Screening For Sell-Rated Market Edge Stocks

Using Fidelity's screener, on Thursday, I scanned for stocks that were rated "sell" by Market Edge and had market capitalizations below $25 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 Market Edge on Thursday were:

  • Kinross Gold (NYSE:KGC)
  • Annaly Capital (NYSE:NLY)
  • Symantec (NASDAQ:SYMC)
  • US Steel (NYSE:X)
  • Peabody Energy (NYSE:BTU)

Kinross Gold was one of the biggest movers on the NYSE on Thursday, with its shares jumping 8.7%, as gold prices hit a two week high. Interestingly, on Thursday morning, Slope of Hope guest blogger Cupiter called a bottom on the Market Vectors Gold Mining Index ETF (GDX) - Kinross Gold is one of the top ten holdings in that ETF.

Annaly Capital investors were cautioned by Seeking Alpha contributor Christopher F. Davis ("Annaly Capital: A Sinking Ship?") to be ready for more pain ahead for the mortgage REIT, though Davis noted he still considered the stock a long-term buy.

Symantec reported record quarterly revenue on May 7th, but its earnings for the quarter, $188 million, represented a steep drop from the $599 million it earned in the year-ago quarter.

US Steel announced on Thursday that its board had elected a new president and chief operating officer, Mario Longhi. Longhi will have his work cut out for him if Goldman Sachs' bearish predictions for the steel sector prove correct.

More than 21 million shares of Peabody Energy traded on Thursday - nearly three times the stock's average volume over the last three months - on speculation that Carl Icahn had plans to buy a stake in the company, a claim Icahn later denied.

Drilling Down On The Ratings

To get a sense of why Market Edge was bearish on these stocks, I reviewed its research reports for each of them. The main negative factors on its report for Kinross Gold were negative earnings, negative return on assets (ROA), negative return on equity (ROE), and negative earnings trend.

For Annaly Capital, the main negative factors were negative operating margin and bearish analyst consensus forecasts for revenue and earnings per share.

Negative factors for Annaly Capital included high long term debt/capital, negative earnings trend, and bearish consensus forecasts for earnings per share.

For US Steel, negative factors included negative earnings, negative return on equity, high long term debt/capital, negative earnings trend, and bearish analyst consensus revenue forecasts.

Negative factors for Peabody Energy included negative earnings, negative ROA, negative ROE, high long term debt/capital, negative growth potential, and bearish consensus revenue and earnings forecasts.

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, US Steel, 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 US Steel

Below are two ways a US Steel shareholder could have hedged 1,000 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 costs more. These were the optimal puts, as of Thursday's close, for an investor looking to hedge 1,000 shares of X 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 5.26%.

2) An X 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 0.44%.

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).

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 X: 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, and also because investors who are well-diversified may decide to let that diversification ameliorate their stock-specific risk, and use optimal puts on SPY to hedge against market risk.

Name

Symbol

Optimal Put Hedging Cost

Optimal Collar Hedging Cost

Kinross Gold

KGC

10.5%

5.49%

Annaly Capital

NLY

2.88%

2.74%

Symantec

SYMC

1.48%

0.83%

US Steel

X

5.26%

0.44%

Peabody Energy

BTU

8.04%

2.03%

SPDR S&P 500

SPY

0.87%

0.75%

*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: Sell-Rated Stocks In A Complacent Market

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