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How To Play The Market Euphoria

Daniel Laboe

Market euphoria is driving share prices to continuously new highs, but how much longer will this rally last with no new information backing it? Employment figures were released this morning, and the results had little effect on the stock market, with 145K additional jobs added (vs. 160K estimate) and keeping unemployment at a half-century low of 3.5%.

Q4 earnings are about to unleash their results onto the markets, and equity bulls are just hoping that these reports are as strong as they have anticipated.

Deloitte surveyed 147 North American CFOs working for corporations with more than $1 billion in annual sales. The survey indicated that 77% of CFO respondents thought the equity market is overvalued, which is up from 63% last quarter and substantially higher than this figure at the beginning of 2019 (which was below 50%). Only 4% said they were undervalued, which is down from 10% last quarter.

CFO’s biggest external concerns include trade policies/tariffs, political turmoil/instability, and economic risks/slowdown. According to the report, “82% of CFOs say they have taken at least one defensive action in response to or in anticipation of a downturn.” This figure is substantially above 54% cited in the first quarter of 2019. The most prominent defensive strategies include reduced spending, reduced headcount, and delay/canceled investments.

This information should not be taken too lightly as these corporate insiders have day-to-day visibility of consumer and business spending. According to the same survey, CFOs are taking an increasing defensive strategy going into 2020.

This CFO sentiment could be a clue into what to expect for the Q4 earnings season. The final quarterly results of the decade could reverse the seemingly unending bullish narrative.

Corporate America is not anticipating a full out recession but rather an economic slowdown in 2020 (agreed upon by 97% of CFOs Deloitte’s survey). This is a fair assessment considering that the markets and the economy have been running red hot in the longest economic expansion in US history.

The US economy has seen strong tailwinds over the past several years that have been able to incubate the stock market’s Bull Run. Corporate tax cuts and falling interest rates set by the Federal Reserve were key catalysts.

I believe that these economic stimuli have been more than priced into stocks and that the market’s continued rally is being fueled by its own elation, causing indiscriminate buying.

How to Take Advantage of The Market Euphoria

Every great trader will tell you never to catch a falling knife, and that the trend is your friend (until it’s not). What I am about to suggest may sound like it goes against these principles, but I will explain why the risk may be worth it.

The options market has been going crazy with this indiscriminate buying and market bears are rushing into puts. SPY SPY follows the S&P 500 and is the most traded ETF on the market. Looking at the options activity, it appears that traders and investors are betting against the market or at least hedging against a potential pullback.

Put activity is substantial today on both the January 17th and February 21st expirations. Put to call ratios were well above 2 for both expirations, meaning that more than twice as many people today are betting/hedging against the market than are leveraging upsides.

Purchasing a February 21st expiration put would hedge your portfolio against the majority of this earnings season downside risks. I would recommend buying this option between $300 - $320 (SPY is currently trading around $326).

The weight you put on this option will depend on your risk tolerance and portfolio size. Remember that if SPY does fall back to your strike price by expiration, you will lose the premium you paid. If the market does correct towards or past your strike, you will see gains that should partially offset your broader portfolio losses.

Another good hedging option would be XLU XLU, the most liquid utility ETF. XLU has a beta of 0.22, meaning that it will act as a long-term hedge for your portfolio against market risk and yields a comfy dividend of 3%. This ETF is currently a Zacks Rank #2 (Buy)

Vanguards Real Estate Index Fund VNQ is another solid ETF for market hedging and also yields a sizable dividend of 3.4%. VNQ is also a Zacks Rank #2 (Buy).

Take Away

Whether this market rally has legs or not will be put to the test over the next month of Q4 reporting. Banks will be kicking off this earnings season next week, and this will set the tone for the rest of the market.

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Click to get this free report Utilities Select Sector SPDR Fund (XLU): ETF Research Reports Vanguard Real Estate ETF (VNQ): ETF Research Reports SPDR S&P 500 ETF (SPY): ETF Research Reports To read this article on Zacks.com click here. Zacks Investment Research