For investors concerned about macro risk looking to hedge their equity portfolios against downturns, a hedge fund style long-short trade may be appropriate. While going long and short individual stocks maximizes return, it's also possible to play secular trends in the market utilizing ETFs.
My idea for a long-short trade revolves around the recent run-up in utilities. Defensive investors seeking yield have bid utilities up to valuations rarely seen:
Normally, utilities stocks have a price-to-earnings ratio of 26% less than the S&P 500. Today, utilities stocks sport a 14.2 P-E, vs. 12 for the S&P 500. And S&P estimates that utilities' earnings will fall 2% next year, [strategist Sam] Stovall says.
So it seems utilities have a fair-at-best future. Where can we find a bright future? Well, technology. There are many stocks in the tech sector with surprisingly low valuations, such as Intel Corporation (INTC) and other companies in the Market Vectors Semiconductor ETF (SMH). For those who follow technicals, the tech sector as represented by the iShares S&P North American Technology-Software Index Fund ETF (IGV) recently broke the 200-day MA to the upside. With tech available on the cheap supported by the emergence of cloud computing and Big Data, tech certainly has more positive secular trends than utilities.
Look at the following chart for instance. The Technology Select Sector SPDR ETF (XLK) had a very strong run during the spring, but the Utilities Select Sector SPDR ETF (XLU) was left behind. In light of the recent sell-off, tech dipped back under utilities.
Click to enlarge
Since tech has positive secular trends in the near future, while utilities have a good amount of room to fall, interested investors could hedge against a "Black Swan" Lehman-type event or the potential collapse of the euro by going long any one of the tech ETFs mentioned and going short a utilities ETF like XLU. With prices already high from a historical perspective, utilities shouldn't appreciate much further, as P/E compression could make their price performance mostly flat even in a rally—but tech certainly has room to run.
Long/short strategies have inherent risk and are only suitable for experienced investors. However, the current divergence between tech and utilities offers interested investors the ability to play the valuation difference by going long tech and going short utilities. This could be accomplished either with the ETFs or by finding particularly underpriced tech companies and particularly overpriced utilities. Such a strategy would hedge against macro risk and a market collapse (with the short position) but enable an investor to take advantage of most of the market gains (with the long position).
Utilities companies with particularly rich valuations include:
- UIL Holdings Corporation (UIL) P/E: 20.3
- ITC Holdings Corp. (ITC) P/E: 21.9
- Duke Energy Corporation (DUK) P/E: 19.7
These companies might be deserving of further research to determine if they're appropriate candidates for the long-short strategy.