A graph of the S&P 500 by itself does not indicate any tension in a market that marches steadily higher. Yet, there is a sense that something is changing. Market reactions to earnings have been harsh in many cases. That is true both for companies with disappointing earnings, such as F5 Networks (NASDAQ:FFIV) and Cree (NASDAQ:CREE), but even many companies with impressive earnings (Apple (NASDAQ:AAPL) being a prime example) have failed to be rewarded with rising share prices. Many of last year’s high-flyers, such as the cloud computing companies, are beginning to show a real change in momentum. Count me among those who think there is a high probability of a pullback in the next couple of months.
My aim is not to change the mind of any bulls out there, but to suggest a couple of options for those interested in playing the short side of the market.
#1 Buying SPY Put Options
After a long bull run with hardly a pause, it is not surprising that implied volatilities on options have fallen substantially. This is good news for those who are interested in buying options. For example, put options on SPY (an ETF that tracks the S&P 500) expiring on March 19, with a strike price of 128 ended Monday at 2.7 per share (SPY ended the day at 129.1).
Not factoring in transaction costs, SPY would have to be at 125.3 at expiration to break even. Were SPY to fall much further than that, the rewards could be large. At 122.6, 5% below current prices, the option gives a 100% return. If the market falls to the lows of November, the returns will be much higher. Of course, you will be left with nothing if the option ends out of the money, so it is crucial to be sensible when it comes to position sizing.
If SPY were to fall considerably between now and expiration, I would consider selling SPY puts with a lower strike price (turning the trade into a bear put spread), thereby lowering the cost of the trade while giving away some upside.
#2 Shorting HOT Shares
I thought Starwood Hotels & Resorts Worldwide (HOT) was expensive at $47 per share last summer (see article). Currently close to $63 per share, it is hard to make sense of the valuation. To put the share price in context with the financials, cumulative earnings from 2000 to 2009 were $19 per share and cumulative free cash flow was $15.6 per share.
The highest earnings estimate for 2011 from the 27 analysts covering Starwood is $1.92 per share, giving the company a forward P/E of 32.6 (40.2 if the average estimate is used instead).
One of two things will have to happen. Either Starwood will find a way to shatter analyst estimates and grow much faster than it has in the past – reveneues in the last reported twelve months were a mere 15% higher than they were in the year 2000 – or the share price will eventually have to come down substantially. A general market drop in the near term might prove the catalyst for the latter. Starwood will report earnings on February 3.