New Trade – $XLP: Your Best Offense Could be Defensive

by CC October 2, 2015 2:25 pm • Commentary

Today’s price action in U.S. stocks is confounding to say the least. The pre-opening 2% sell off from the highs on the worse than expected Sept jobs data made sense in the context of our world view, but the reversal off of the lows makes absolutely no sense. Investors are cheering the fact that weak domestic data puts the FOMC’s rate liftoff on hold even longer.  It’s been our view that if the FOMC does not raise interest rates in 2015 it will be for all of the wrong reasons, and those reasons will not be bullish for stocks. But with the rally in equities today, investors don’t agree with our view. For now.

Over the last few weeks we have detailed a few different trades that we think make sense in a continued low rate environment. A low rate environment that does not exist for reasons that may induce higher stock prices:

Sept 11th: New Trade $XLU: Utility Playa

Trade: XLU $41.40 Buy Oct 42/44 call spread for .50

Sept 21st: Name That Trade – $TLT: Treasury Island

Hypotehtical TLT trade ($120.15) Buy Dec 120 / 130 Call Spread for $2.50

These trade ideas have been working as they were first conceived at time when investors seemed to be caught off sides on the FOMC’s intentions.

We think today’s price action sets up a similar situation and we think it makes sense for investors to consider the potential for a string of weaker than expected jobs and wage data. Therefore a more defensive equity positioning makes sense.

Consumer Staple stocks could be interesting as most of the large components of the XLP (the S&P Consumer Staples etf) have spent the better part of 2015 trending lower as a result of the adverse affects of the strong dollar and their exposure to emerging markets.  It’s possible a lot of the damage has been done. And it’s also possible that on a relative basis, staples start acting better than some high valuation sectors. PG, KO and PM make up nearly 30% of the XLP, and all three appear to be showing decent relative strength. And all have dividend yields between 3 and 5%.

Short dated options prices in the XLP are very reasonable in the high vol environment we are in, especially relative to other large sectors, like healthcare, tech and financials. Thirty day at the money implied vol is at 16.7%, up from the 10% support level it bounced off of on numerous occasions throughout 2015 but down from its recent high just below 30%:

XLP 1yr chart of 30 day at the money implied vol from Bloomberg
XLP 1yr chart of 30 day at the money implied vol from Bloomberg

From a technical standpoint, the etf faces fairly stiff resistance at the August breakdown level of $48, but as I stated above the recent consolidation in and around $47 shows decent relative strength, with the sector down about 1% on the year vs the S&P500 (SPX) down about 6.3%:

XLP 1yr chart from Bloomberg
XLP 1yr chart from Bloomberg

On a longer term basis, the 6 year chart below shows the stock sitting on the uptrend that has been in place since 2010, a hold here could mean a move back to $50:

XLP 6 yr chart from Blomberg
XLP 6 yr chart from Blomberg

Near term we think it makes sense to diversify out of high valuation growth, or economically sensitive areas like transports and industrials and start to think defensive. Consumer staples which have been hard hit from their highs, have strong balance sheets, high capital returns and deemed to be defensive could be the place to be. So here’s the trade:

Trade: XLP ($47.45) Buy to Open Nov 47 call for $1.45

Break-Even on Nov expiration:

Profits: above $48.45, up 2%

Losses: up to 1.45 (or 3% of the underlying stock price) between $47 and $48.45 with max loss of $1.45 below $47.

Rationale: the etf shows good relative strength, the underlying stocks could become of interest again due to their high div yields, the products they sell are defensive, and the options are cheap relative to the broad market.  We will possibly look to spread on a move higher in the near term.