XLV – Healthcare Scare

by riskreversal December 2, 2016 3:01 pm • Trade Ideas

Yesterday I discussed the sector rotation since the presidential election results on Nov 9th:

I sincerely have no idea whether the rotation out of growth stocks, primarily Tech, and “yield-ers”… Consumer Staples, Telco and Utilities, into Banks, Industrials, Materials and Oil stocks is healthy with the broad market at all time highs.

I get why investors have a new found optimism about bank stocks given the rise in interest rates and the prospect for a more lenient regulatory environment. I get why oil stocks caught a bid with the news of the production cut from OPEC, despite the recent rise in the dollar. I get why Industrial & Materials stocks have ripped on the promise of a massive infrastructure plan. And I get why Consumer Staples stocks have gotten walloped with the dollar rise given their overseas exposure.

But have we gone to far too fast overall? I have no idea. But the give back in Biotech/Pharma, and the out-of-the-gate weakness in Tech is troubling. Biotech/Pharma that initially saw a sharp post election pop has since given back much of their gains as a group and seems poised to fill in the gap.

It’s that last comment I want to focus on. Regular readers are aware that prior to the election, it was our view that no matter who won (and we thought Clinton was more likely) that Biotech/Pharma stocks, which had been beaten down by the prospects of greater regulatory scrutiny by Democrats, would have a relief rally.  At the time we chose to express this view via a January call spread in the XBI, the S&P Biotech etf (initially here from Oct 21st, and altered here on Nov 22nd).  We are going to keep this one on a tight leash.

Which leads me to a similar giveback in big Pharma stocks, specifically the XLV, the Health Care Select etf which is a bit more diversified away from Biotech than the XBI, and skewed towards big Pharma, with Johnson & Johnson (JNJ), Pfizer (PFE) and Merck (MRK) making up 25% of the weight of the etf. The XLV has essentially filled in its entire post election earnings move. One big reason for the weakness might be these large components exposure overseas, and the U.S. dollar’s (DXY) 3% rise since Nov 8th to new two year highs:

DXY 2yr chart from Bloomberg
DXY 2yr chart from Bloomberg

The next real catalyst for the U.S. dollar is likely the Fed’s Dec 14th rate decision. The sharp move in rates in front the meeting has put upward pressure on the DXY, but the potential that the increase is now baked into the cake, and that the Fed is not likely to make the same mistake as they did last Dec by signalling 4 increases in the upcoming year, the DXY might come in a tad, along with upward pressure in rates moderating, making yielders attractive (JNJ, PFE & MRK have dividend yields between 2.9 and 3.5%).

The XLV has two, count em two up days after the election, and has since been in a sharp downtrend back to its Nov 8th close, with what appears to be healthy technical support at $66:

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

The XLV is the worst performing sector etf year to date, which also sets up the potential for an early 2017 “dogs of the dow” sort of trade.

From SeekingAlpha.com
From SeekingAlpha.com

But as we head into year end, following the Fed meeting we could see some sideways trading the closer we get the Christmas holiday, which makes long premium directional strategies unattractive.

So what’s the trade? 

If you are inclined to play for bounce in the XLV over the next month and half it makes sense to consider strategies with minimal premium outlay.  Zero cost risk reversals offer a good risk reward defining a range where you would get long on the upside, allowing room for error on the long entry:

Trade: XLV ($68.50) Buy Jan 66/70 Risk Reversal for a 5 cent credit
  • sell to open 1 Jan 66 put at 80 cents
  • buy to open 1 Jan 70 call for 75 cents

Break-even on Jan expiration:

Profits: above $70

Losses: below $66, down 3.5%

Mark to Market: as the stock moves higher towards the long strike prior to expiration the position will show gains, and as it moves lower towards the short put strike the position will show losses. If the stock is between $66 and $70 on Jan expiration the trade makes the 5 cent credit.

Rationale: This trade idea plays for a bounce in XLV where above 70 it is like being long the etf on Jan expiration. And below 66 it is like being long the stock on Jan expiration. 66 is the breakdown level and would be a place many would take a shot or place a GTC order. 70 is where there is some reistance and if the etf broke above that it could run a little. Anything in between 66 and 70 is like a free look.