20 Potential Hedges if QE Sails and Markets Hit a Valuation Iceberg

by: Hedgephone

Over the past year or so, one of the main factors propping up equity and arguably commodity markets (although supply shortages can be blamed for commodity price increases as well) has been the constant intervention by the Federal Reserve Board of Governors. Short covering, rally chasing, index fund popularity, and many other factors have contributed to the equity market rally, but no one-- not even Dr. Bernanke himself-- can deny that Quantitative Easing has played a major role in driving the markets to new highs. Equities have rallied tremendously despite high unemployment, stagnant wages, failing regional banks, and generally depressed levels of economic activity. In short, the economy is not doing very well, but equity markets are climbing faster than almost anyone in the markets had expected (except, of course, the long only investment managers who really have no choice but to be resolutely bullish at all times).

QE 1, QE2 and the incredibly low interest rates have driven what Nouriel Roubini and Marc Faber have dubbed a "Crackup Boom" in pretty much every asset class priced in dollars aside from Real Estate. Food prices have doubled, gold prices are up by 40%, silver has doubled, sugar has doubled, and stocks have gone up some 30% off of the summer lows. Much of the rise in asset prices can be viewed as a result of a crashing dollar, which has dropped some fifteen percent from its highs last April when Quantitative Easing part one was withdrawn.

What remains to be seen, however, is what will happen when the economic stimulant that is Quantitative Easing Two is withdrawn, and equity markets have to find legitimate price discovery as they did last April. Already, most of the "valuation shorts" have covered their positions as it has been pointless trying to fight the tape even in stocks trading at insane price to earnings ratios such as OpenTable (NASDAQ:OPEN) and Salesforce.com (NYSE:CRM) -- so who is left to buy stocks once the funny money stops flowing? Well, it certainly won't be the general public who is facing huge grocery and gasoline bills, or the Federal Reserve member banks who will be facing their own liquidity issues once the FED stops handing them free money to day trade with. The only logical conclusion, in this humble investor's mind, is that once the printing stops, so too will the questionable rally we have seen in the stock market.

Here are 20 longer term short sale candidates and how to play them using options.

iShares Russell 2000 Index Fund (NYSEARCA:IWM) -- Calendar put spreads seem like a good way to play the Russell 2000, which is trading for a PE ratio of over 30X reported earnings excluding companies losing money. Investors looking to hedge their portfolios can buy the January 2012 $92 IWM put options for a relatively small premium and can sell the May $80 put options for a "long hedge" that will profit from time decay.

PowerShares QQQ Trust ETF (NASDAQ:QQQ) -- The Nasdaq 100 is losing its huge weighting in Apple (NASDAQ:AAPL), which is likely bearish the overall index fund as companies such as OPEN and Amazon (NASDAQ:AMZN) will gain a larger weighting in the index. Phil Davis has done an excellent job explaining how this change has driven many of the more speculative issues higher despite downright insane valuations. Investors looking to hedge risks to their Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Hewlett Packard (NYSE:HPQ) holdings could sell the May $58 call options on QQQ for a hedge or can buy the January 2012 $62 put options and sell the May $53 put options for a Calendar Spread trade.

The Midcap Spyder (NYSEARCA:MDY) is hitting new highs yet again, while the valuations on cash flow and book value simply do not support such a move higher. Once QE ends, the domestic smaller companies will likely be under pressure, so investors may consider selling the June $180 call options in the MDY either as a hedge to their mid cap names or an outright bet on a weaker stock market.

Salesforce.com (CRM) shares are trading at a level which makes little sense from a bottoms up, fundamental analysis point of view. In fact, shares of CRM trade for over 250X reported earnings and for a nosebleed level on sales and book value. Cash flows are driven to a large degree by increasing short term liabilities, which is not the kind of cash flow that comes from healthy business growth as much as it does from borrowing more money. The CRM $145 May call options appear to be a good short play for those wishing to play the short side without all of the risks involved.

Opentable.com (OPEN) is the ultimate short squeeze stock which is priced beyond perfection at 188X reported earnings and over 23X revenues. Investors are more than just a bit optimistic here, and if the economy slows, families will likely be eating out a lot less than they are currently. Add that to the fact that higher food prices will push menu prices higher and you get a pretty good reason to actually short this stock at current levels. Investors looking to short OPEN can sell the January 2012 $120 call options or sell the May $100 put options against their short stock position for a bit of a cushion.

Travelzoo (NASDAQ:TZOO) is likely the best performing online travel stock of the year so far, and with all of the hype surrounding Groupon, these shares have gotten a real boost as of late. The only trouble is, that this story is getting old and the valuation is getting truly rich -- 90X earnings is a bit much for the stock . This stock made the same parabolic move a few years back, topping out at around $100, only to come tumbling down to a price below $10 a share just two short years ago -- what short memories traders on Wall Street have.

Netflix (NASDAQ:NFLX) is a good business in a good market. As people stay home to watch movies instead of hitting the town due to higher oil and gas prices, this stock will likely continue to find some support. However, the valuation, at over 80X earnings, leaves most bottoms up investors scratching their heads. Investors looking to short this stock should consider a bear call spread, selling the June $250 calls for example, and buying the June $280 calls in equal amounts.

Amazon (AMZN) is another darling of the "online revolution" that is happening in the tech stock world. The company trades at over 70X reported earnings and the stock has been fairly resilient over the past six months. Investors looking to play the short side should buy the June $195 puts and sell the June $180 puts for a bear put spread.

Junk bonds (NYSEARCA:JNK) are once again all the rage, and the spread between Treasuries and junk has become very tight. If the economy heads back towards recession after the stimulus party ends, junk bonds may not look so attractive at current yield levels. Furthermore, rising interest rates will pressure highly leveraged companies and investors may hesitate before buying high yield debt for such a low level of return.

iShares Lehman 20+ Year Treasury Bond Fund (NYSEARCA:TLT) -- U.S. treasuries are going to be in serious trouble if QE ends. Reports are stating that the U.S. is buying up to 70% of these bonds at auction as it appears that nobody else wants to touch our debt. Japan has reportedly been selling our bonds to pay for their rebuilding efforts, and China will likely be looking to diversify out of U.S. assets given our seeming inability to rein in government spending. The question remains valid: who will buy our debt when QE ends and at what price will these buyers step in with any conviction?

ProShares UltraShort Lehman 20+ Year Treasury ETF (NYSEARCA:TBT) -- TBT is a leveraged way to short the U.S. longer dated treasury market. Bond prices move inversely to changes in their yield, so as prices fall the yields rise and vice versa. Longer dated bonds-- such as the 10 year and 30 year bonds-- move in wider swings than short term bonds, and TBT is a way of shorting the long bond for extra kick in case the U.S. bond market suffers and interest rates rise once the U.S. Fed leaves the Bid and hits the offer.

Green Mountain Coffee Roasters (NASDAQ:GMCR) is a stock that the momentum and short squeeze crowd absolutely loves. At a PE of over 100X, however, GMCR may be due for a substantial pullback. Personally, I am a huge fan of the K Cup concept and like the taste of the coffee these machines produce. However, as someone who knows value, I believe investors buying the stock at current levels could be left with a bitter taste in their mouths going forward.

Financial Select Sector SPDR (NYSEARCA:XLF) -- Financial stocks have not enjoyed the monster rally of late, and once QE ends many bears believe that financials will once again fall off the proverbial cliff. I am more or less a bull on a few of the financials in the insurance space, as many of those names are undervalued based on net asset value. However, the bigger financial institutions are saddles with trillions of off balance sheet liabilities and risks that are simply too complex to effectively quantify, in my opinion.

Hitachi (HIT) is a cheap stock but it remains in a bad industry and an even worse location -- Japan. HIT could take a hit as the Japanese situation appears even worse than most analysts had imagined. If more earthquakes erupt in the country, expect shares of U.S. listed Japanese businesses to significantly underperform, regardless of current low PE ratios.

The Retail Holders Trust (NYSEARCA:RTH) is making new highs and many investors are actually bullish on the fund, even though just a few short months ago it seemed that almost every hedge fund in existence had a large short position in this index. If the economy turns south, expect the RTH to lead the decline much as it has led the rally.

The Russell 2000 Growth Index (NYSEARCA:IWF) has surged along with the rest of the market, but the index fund is now facing some steep valuation risks, and possibly undue optimism, if QE is stopped and the markets are to trade at a reasonable price to earnings ratio or price to cash flow ratio.

Simon Property Group (NYSE:SPG) is a REIT which trades for nearly 30X free cash flows. The company is a large mall owner and has been a short squeeze play for some time now. If QE is taken away, however, it will be hard to keep the momentum going forward, so look to sell calls as a hedge against your retail or REIT longs here once the QE bonus is taken away in earnest.

The Vanguard Reit Index (VNH) has been another beneficiary of the QE stimulus short squeeze, but watch out as the main components in this REIT ETF appear to be markedly overpriced.

The Direxion Triple Leveraged REIT Index (NYSEARCA:DRN) looks to be a good place to add hedge exposure if the market turns, as the daily nature of the leverage makes this a bad long term investment in general, and the withdrawal of QE may turn this into a fantastic short sale candidate moving forward.

The triple leveraged Russell 2000 index (NYSEARCA:TNA) suffers from the same under-performance as many of the triple leveraged funds in that it does not hold to its objectives over longer periods of time. Investors looking to hedge their small and midcap holdings should consider selling TNA call options once it is clear that QE two will be taken away in full.

Disclosure: I am short IWM, CRM, OPEN, NFLX, MDY, TNA, GMCR, HIT, SPG, IWF, QQQ.