This Sector is Priced for the Apocalypse, but Not for Long
In addition to huge daily swings, 2016 has been characterized by a flight to safety as the markets sharply corrected in the first few weeks of the new year.
Even though stocks have regained some of those losses in the past few weeks, the only sectors to show year-to-date gains are defensive utilities and consumer staples. In fact, the stampede to safety has pushed the latter to multiyear highs and lofty valuations.
If the economic landscape is not as dire as many investors think in 2016 — and I don’t think it will be — we have a chance to capitalize on our fellow investors’ irrationality with a trade that could land you 78%.
How Much are You Willing to Pay for Safety?
I compiled the weekly returns of the Consumer Staples Select Sector SPDR ETF (NYSE: XLP) going back to its launch in 1998. Between Nov. 16 and Feb. 8, XLP outperformed the S&P 500 for 12 consecutive weeks, which has never happened before in the history of the fund.
In addition to the recent rush to safety, the sector has benefited for years from yield-seeking investors leaving lower payouts in bonds for higher income in dividend stocks.
These factors combined to help push the sector to its highest valuation in 12 years at over 21 times trailing earnings.
The consumer staples sector is now trading at a higher valuation than all of the sectors shown below except energy, which is something of an outlier because of the dramatic decline in energy companies’ earnings.
What’s more, the consumer staples sector has a forward P/E of 20.3 — a 20% premium to its five-year average of 16.9.
In short, defensive is getting expensive and the flight to safety appears overdone.
There’s good reason to believe the bull market still has room to run in 2016.
First, fears of an imminent recession may be overblown. Economists at Goldman Sachs (NYSE: GS) put the chances of a U.S. recession this year at just 18%, and they see only a 23% likelihood of one over the next two years.
Second, the American consumer is looking as healthy as ever. Household income jumped 4.5% last year, the largest increase since 2012, and disposable income saw the biggest increase since 2006. Household savings hit a three-year high in December, tallying $753.3 billion.
So it’s not surprising that the smart money already appears to be shying away from overbought consumer staples. A research team at Bank of America (NYSE: BAC) looked at changes in investments by big money institutional players over the past three months and found that consumer staples came out as the biggest sector underweight.
Make a Potential 78% as XLP Comes Back Down to Earth
The search for yield may help support prices in the consumer staples sector somewhat, but any broader market strength could have investors jumping ship for stocks with better growth potential. I see XLP falling back to at least the $47.30 level over the next few months, which would give it a more reasonable valuation.
That is about 8% below the current price, but using a simple put option strategy, we can leverage that move into a 78% gain while putting less money at risk than we would with a traditional short position.
With XLP trading for $51.24 at the time of this writing, we can buy an XLP Jun 50 Put for around $1.52 per share. That is a put option with a $50 strike price that expires on June 17. Each contract controls 100 shares, costing you $152 per contract.
The trade breaks even at $48.48 ($50 strike price minus $1.52 options premium), which is 5% below the current price.
If XLP hits my $47.30 target by expiration, the option will be worth at least $2.70 ($50 strike price minus $47.30 stock price) for a 78% return in less than four months. Place a good ’til cancelled (GTC) order to exit at this price.
That 78% gain works out to an annualized return of 249%, which really highlights the benefits of buying puts.
My colleague Jared Levy has recommended simple put option trades just like this for annualized returns of:
— 3,080% in iShares Russell 2000 Index ETF (NYSE: IWM)
— 2,797% in Alibaba (NYSE: BABA)
— 2,532% in SPDR S&P 500 ETF (NYSE: SPY)
— 2,308% in Kinder Morgan (NYSE: KMI)
— 2,111% in Dillard’s (NYSE: DDS)
And these are just a few of the winners he has closed for 1,000%-plus profits in the past year. Click here to get his next trade risk free.