Protecting Against an Earnings Crash

Protecting Against an Earnings Crash

Much like Santa Claus, I came bearing a gift on Christmas Eve, advising you to sell the Santa Claus rally.

In the weeks that followed, the S&P 500 tumbled more than 10%.

While I’m a bit late to be the Easter Bunny, I have another gift today: Sell the first-quarter stock market rally.

Since bottoming on February 11, the S&P 500 has rallied more than 10%, but it has done so with false hope. Investors are speculating that the U.S. economy is rebounding due to stabilizing oil prices and a reversal in the dollar. Because of this, many investors are expecting first-quarter earnings to top expectations.

This assumption couldn’t be further from the truth. In fact, the first quarter is shaping up to be one of the worst since the Great Recession.

Almost a year ago to the day, our investment director Jeff Opdyke explained that the U.S. economy was in an earnings recession. Little has changed during the past year, as the economy is still struggling with earnings growth.

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In fact, if the first quarter of 2016 ends up declining, it will be the first time since 2008/2009 that we have seen four consecutive quarters of year-over-year earnings declines … and yet, investors remain optimistic, sending the CBOE S&P 500 Volatility Index (VIX), aka the fear index, tumbling to six-month lows.

Analysts, however, are expecting only three of the 10 major sectors to report positive earnings growth — telecommunications, consumer discretionary and health care.

Earnings for the other sectors are expected to tumble in the first quarter, with S&P 500 companies’ earnings falling by 8.5% on average. And, as I pointed out last week, this sickness is spreading far beyond the energy sector.

In other words, the U.S. economy is headed for a rude awakening — one from which you can gain protection by simply adding an S&P 500 put option to your portfolio. Let me explain.

Negative Earnings Growth

With low oil prices, it’s not surprising that the energy sector remains the worst in terms of growth. But what is surprising is that other sectors that should be thriving in a low-cost energy market, like technology, financials, industrials, materials, utilities and consumer staples, are all seeing negative earnings growth.

Protecting Against an Earnings Crash

I purposefully left the energy sector out of the above chart because its expected earnings growth is minus 101%, which skews the chart dramatically. But, as you can see, economic weakness is no longer solely confined to the oil market. Tech stocks, financial companies and other economically driven industries are showing negative expectations.

The collapse in the oil market was supposed to be just that — an isolated collapse in oil-related stocks. But this contagion has now spread, weakening economic growth across the board. In fact, this infestation goes beyond weakness in energy prices, and hints at fundamental economic issues in the U.S. and around the globe.

Already, about 20% of S&P 500 companies have issued guidance below first-quarter expectations, of which two-thirds come from technology, health care and consumer companies — not the energy sector.

Jeff has discussed this development many times before. Oil prices and the U.S. economy don’t operate in a vacuum. In other words, a drop in oil prices means that a lot of high-paying jobs are gone, investments from oil companies are gone, and thus, jobs in other industries disappear, ultimately impacting the American consumer.

As you can see, we are seeing early indicators that this energy-sector contagion is spreading to other sectors.

Put on Protection

With the American economy currently experiencing a year-long profit recession, tightening Federal Reserve monetary policy and economic growth slowing to a halt, I think 2016 will see stocks finish lower, or, at best, flat for the year.

That’s why I continue to recommend adding protection during market rallies, to safeguard against declines like the one we saw following the Santa Claus rally, and like the one we are likely to see following the most recent market rally.

The easiest way to protect your portfolio from a decline in stocks is with a broad-market put option, typically on the S&P 500. Such a put position can protect your portfolio from an overall market slide, like we saw in 2008.

My current recommendation is to buy to open a January 2017 $200-strike put option on the SPDR S&P 500 ETF (NYSE Arca: SPY). The SPY is an exchange-traded fund (ETF) that tracks performance on the S&P 500. This particular option will give you broad exposure to a market decline, which I believe we will see in the months to come.

Regards,
Protecting Against an Earnings Crash
Chad Shoop
Editor, Pure Income