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A Market Melt-Up: Bearish For Health Care Stocks?

In his Lead-Lag Report on May 22nd ("Headed for a Crash or another Melt-Up?"), Michael Gayed noted that as the broader market, represented by the iShares S&P 500 Index ETF (IVV), had struggled recently, health care stocks, represented by the Health Care Select SPDR ETF (XLV), had outperformed, and that a broader market melt-up could lead to a period of relative underperformance for health care stocks:

Health care's outperformance has gone vertical as severe market deterioration persisted last week. Health care is now sitting at ratio resistance, and could quickly reverse leadership should markets stage a comeback in the very near-term from oversold levels.

As of Friday, May 25th, the S&P 500-tracking ETF had outperformed the Health Care Sector ETF for the week, as the chart below shows:

It will be interesting to see what Gayed's take on this is -- whether he thinks it's the beginning of a broader market uptrend (corresponding with a period of underperformance for health care stocks). Perhaps he will address it in his next Lead-Lag Report. In the meantime, for investors long health care stocks and considering hedging them now, the table below shows the costs, as of Friday's close, of hedging five leading health care stocks against greater-than-20% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've added the Health Care Select SPDR ETF (XLV) to the table. First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal put option contract to buy to hedge one of the health care stocks below, Abbott Laboratories (ABT).

About Optimal Puts

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 Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% decline thresholds for each of the names below.

The Optimal Puts for ABT

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of Abbott Labs against a greater-than-20% drop between now and November 16th. A note about this optimal put and its cost: to be conservative, the app calculated the cost based on the ask price of the optimal put. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).

Hedging Costs as of Friday's Close

The hedging costs below are as of Friday's close, and are presented as percentages of position values. The stocks are listed in order of their prominence within the Health Care Select SPDR ETF, with the largest component, Johnson & Johnson, listed first.

Symbol

Name

Hedging Cost

(JNJ)Johnson & Johnson1.22%*
(PFE)Pfizer, INc.2.98%***
(MRK)Merck & Co. Inc.1.68%*
(ABT)Abbott Laboratories1.70%**
(UNH)United Health Group, Inc.5.22%***
(XLV)Health Care Select Sector SPDR6.81%***

*Based on optimal puts expiring in October

**Based on optimal puts expiring in November

***Based on optimal puts expiring in December

Source: Insurance For Health Care Stocks