Annual Check-up – $XLV

by Dan May 27, 2016 1:23 pm • Commentary• Trade Ideas

Tuesday morning, right before the S&P 500 (SPX) ripped 2% in a straight line into today, I offered a quick take on the technical set up of the index using a few time-frames (MorningWord 5/24/16: Fool Me Twice? – $SPX).  To be clear, I have taken a less than sanguine view of the price action of the largest stock market in the world for more than year and a half, and specifically. I’ve been focused on the two lower lows since the May 2015 all time highs, and most specifically, the February low, which was the first lower low in the index since the start of the bull market in March 2009.  On Tuesday’s Fast Money on CNBC, I did say that the one thing that would change my mind would be a new high in the SPX, followed by a new base above the prior high, thus establishing a new range.

This morning I was locked out of my office for a bit, and was doing a little work on my iPhone and the chart of the SPX on my Bloomberg Anywhere app looked very different than the charts that I draw on that come to life of my desktop through my $25k a year Bloomberg terminal, and I tweeted the following:

The point here is simple, if I didn’t know that chart was the largest equity index in the world that has shown remarkable relative strength to every other equity index in the world over the same time period, I might consider buying it. But knowing what I know about global growth, and just how fragile our own economy is, with the SPX less than 2% from its all time highs, I have a hard time buying this breakout.

But maybe there are some potential breakouts I can get behind.

For instance look at the chart of Bristol Meyers (BMY), the stock looks poised to establish a new range:

BMY 1yr chart from Bloomberg
BMY 1yr chart from Bloomberg

BMY trades at about 1x its expected PE growth of about 28%, that’s kind of high by big Pharma standards, but the company could be on the cusp of a huge product cycle with an oncology drug launching, and a PE/G of 1 with expected double digit sales growth in the sectors seems more than fair.

Also in mega-cap big Pharma-Tech, Abbvie (ABBV) trades about 13x expected eps growth of 11% on 12% expected sales growth, pays a dividend that yields 3.6% and could also be on the cusp of establish a new range, with room to run to the prior highs, about 10% higher:

ABBV 1yr chart from Bloomberg
ABBV 1yr chart from Bloomberg

I could go on and on with big cap pharma (regular readers know we have been long and overwriting Pfizer all year), but now with the SPX on the cusp of a potential break to new highs, it makes sense to consider what sectors might play catch up, or some instances continue to lead.

Pharma stocks, which have been battered by the adverse affects of the end of ZIRP (slower M&A) and by the political and regulatory environment of an election year could be a that group. Maybe the latter pressure abates a bit. And regardless of whether the broad market makes a new high, big Pharma leaders could make new highs, and laggards could play catch up.

To express this view I want to look at the XLV, the S&P Healthcare Select etf, where Johnson & Johnson (JNJ), Pfizer (PFE), Merck (MRK), United Healthcare (UNH) & Bristol Meyers (BMY) make up about 35% of the weight of the etf, all within striking distance of 2016 and 52 week highs.

The 4 out of the 5 next largest holdings, Amgen (AMGN), Biogen (BIIB), Medtronic (MDT), Abbvie (ABBV) & Allergen (AGN), which make up about 20% of the index, with all but MDT at least 10% from their 52 week highs:


If the top 5 breakout, and the next 5 play catch up, then the XLV could make a run to its prior 52 week high in the high $70s:

XLV 1yr chart from Bloomberg
XLV 1yr chart from Bloomberg

Short dated options prices in the XLV are cheap as chips, with 30 day at the money implied volatility (the price of options, blue line below) at more than 10 month lows, just crossing below 30 day realized volatility (how much the etf has been moving, white line below):

XLV 1 year chart of 30 day atm IV vs RV from Bloomberg
XLV 1 year chart of 30 day atm IV vs RV from Bloomberg

So What’s the Trade?  

With vol quite low it makes sense to keep it simple and play for a near term breakout:

*XLV ($71) Buy the July 71 call for $1.25

Break-even on July expiration:

Profits: above 72.25.

Losses: up to 1.25 below 72.25 with total loss below 71.

Rationale – If XLV plays catch up with the broader market and some of its biggest holdings are able t break out the etf could work its way back towards its highs over the Summer. This simple call purchase can be spread to reduce premium risk on moves higher and we’ll keep a 50% premium stop in case it goes lower from here over the next few weeks.