This Blue Chip’s Drop Could Land Traders Huge Profits
As we kick off the first-quarter earnings season, it seems the dismal trend in corporate profits continues to go unnoticed by investors… at least for the moment.
The S&P 500 is expected to post its fourth consecutive quarter of falling earnings and fifth consecutive quarter of lower sales, the worst run since the financial crisis. Yet, in their usual exuberance, investors have bid up the index within spitting distance of its all-time high. And individual stocks are trading with earnings multiples that are well above their long-term averages despite undeniable bearish macroeconomic factors.
Corporate management needs to start tempering expectations for the second half of the year. If they don’t, this could wind up being the biggest short of the year that nobody sees coming.
Q1 Estimates Go From Bad to Worse
In the past three months, analysts have lowered their first-quarter earnings estimates for S&P 500 companies by 9.6%, according to FactSet. That’s nearly double the average 5.3% decline in expectations over the past decade, and analysts now forecast an 8.5% year-over-year decline in Q1 profits.
Of the 121 companies that have issued guidance for the first quarter, a record 94 have warned of lower earnings, the most since FactSet began collecting the data in 2006.
Forecasters expect profits to fall in Q2 as well, before rebounding in the second half of the year. Current estimates put full-year earnings growth at 2.2%, but this may be overly optimistic.
If earnings do indeed contract this quarter and next, it will mark five consecutive quarters of earnings declines. According to data compiled by Bloomberg, in six of the seven instances in which we have seen five straight quarters of contracting earnings since 1970, stocks have fallen into a bear market.
One sector that could be in for a rude awakening if the profit picture does not miraculously recover to meet investor expectations is the industrials.
First-Quarter Earnings Could be a Nightmare for the Industrials
The industrial sector looks especially weak, as the strong U.S. dollar has been hurting export demand and taking a big bite out of foreign earnings. At the same time, low commodity prices and slowing global growth have made for an extremely weak pricing environment.
In the fourth quarter, industrials posted a 4.2% year-over-year drop in earnings on a 7.3% decline in revenues. And things may be about to get worse.
Of the 15 industrial companies that have issued earnings guidance for Q1 thus far, 14 expect profits to decline. Overall, analysts project earnings will fall 8.9% on a 2.8% drop in sales.
Yet, the sector still trades at 16.1 times expected 2016 earnings, a premium of 10% on the five-year average valuation. I believe industrial stocks are going to have a hard time justifying their valuations once first-quarter earnings start rolling in.
Few industrials look as overvalued as blue-chip General Electric (NYSE: GE).
Shares are up 12% over the past year, handily outperforming the 1% drop in the Industrial Select Sector SPDR ETF (NYSE: XLI). The stock now trades with a forward P/E of 17.9, which is an 11% premium to its industry average, and for 2.6 times trailing sales, a 63% premium to its five-year average.
GE’s acquisition of the power business of France’s Alstom last year left it even more exposed to the industrial sector’s problems. European assets now make up 38% of total assets versus 31% in 2014, and international revenue accounts for more than half of total sales (55%).
Currency effects wiped out $4.9 billion in sales in 2015, with total revenue dropping 21% That number would have been $2.5 billion lower were it not for the Alstom acquisition, which accounted for nearly all of GE’s 3% organic growth.
Analysts expect General Electric to post earnings of $0.47 per share in the first two quarters of the year, which is down 7.8% from the first half of 2015. Meanwhile, revenue is expected to rise just 1.2% to $59.8 billion. Despite the slow start to the year and continued industry pressures, GE’s full-year revenue is expected to increase by 7.7% to $126 billion, and earnings are expected to improve by 14.5% to $1.50 a share.
I find it highly unlikely that GE will be able to orchestrate the kind of sales and earnings growth the market is expecting this year, and the company may need to manage expectations by lowering guidance.
This gives us a prime opportunity to profit with a simple put options strategy.
Make a Potential 150% From an 8% Drop in GE
With GE trading for $30.98, we can buy a GE Jun 31 Put for a limit price of $1 a share. That is a put option with a $31 strike price that expires on June 17. Each contract controls 100 shares, costing you $100 per contract.
The trade breaks even at $30 per share ($31 strike price minus $1 options premium), which is 3.2% below the current price.
My downside target for GE is $28.50. That’s 8% below the current price and 2.1 times expected 2016 sales, which still may be optimistic given macro headwinds.
At this price, the option would be worth at least $2.50 ($31 strike price minus $28.50 stock price) for a 150% gain in just 65 days. Place a good ’til canceled (GTC) order to sell the option at $2.50 when you open the trade.
General Electric is scheduled to report earnings on April 22, and by the time these options expire in June, most companies will have released their reports. As investors come to grips with the reality of lower earnings, stocks across the board are likely to correct. So today’s trade also offers a way to offset some of the near certain pain heading investors’ way.
I’m not the only one who thinks stocks are getting way ahead of earnings. My colleague Jared Levy recently told his Pro Trader subscribers about a way to capitalize on earning weakness as we head into a notoriously bearish time of year.
But as a former floor trader, Jared knows first-hand just how irrational markets can be, which is why his bearish trade can profit whether the S&P 500 falls, stays flat or even moves up. In fact, all the index has to do is stay below 2,145 and they will book a 17.6% profit in the next five weeks.
Since Jared left Wall Street, he has been teaching others how to use his strategy…
Like a farmer in Iowa who lost $33,800 from his IRA account and decided to give up on the stock market. But within three months of following Jared’s work, he not only recouped his losses but made $45,000.
There’s also Jeff R. from Texas, who said he made over $50,000. And Jared helped his friend Terry make $8.5 million in a single year.
Jared has put together a free presentation about his strategy that is available for a limited time by clicking here.