I believe that the S&P 500 is overpriced and due for at least 8-10% correction in the coming 9 months. I would take advantage of this mispricing using a long put option on S&P 500 Mini options (XSP). Very simply put, the S&P will rise if the component firms’ sales increase, margins improve, or if the stock market is seen as a risk-haven compared to other asset classes. I believe that none of the three scenarios are likely in the coming quarter.
Sales: More than 70% of the economic data released in the last month or so have been disappointing. The latest PMI and NMI reports from the ISM seem to show that the recovery peaked in Feb. The dip in Factory Orders, to -0.1% in Feb from 3% growth for the past two months prior confirms the deceleration. Recently, there was much celebration post the BLS release for the month of March, but it is worth keeping in perspective that the US has recovered only 17% of the jobs lost in the recession—hardly a recipe for a consumer-led economy we’re used to. That the employment growth has consistently come from the part-time jobs speaks volumes about business confidence. Consumer confidence has also taken a sharp turn for south (from 70.4 in Feb to 63.4 in May), with food and gas prices weighing most heavily in consumers’ minds. In addition to residential housing numbers, Architect’s Billing Index, which is considered a leading indicator of commercial housing, has softened. Overall, both consumers and corporations are less likely to spend. With governments in fiscal restraint, it is hard to see who’ll drive sales. There have been murmurs that the global economy continues to expand, and that the US firms benefit from that. But, a quick look at BEA Corporate Profits shows us that the profits emanating from foreign shores have been decreasing at the rate of about 9% for the last two quarters.
Margins: Overall S&P 500 margin of 8.2% is very close to the peak of 8.6% reached in the last business cycle. Recent economic data suggests that there is little room left for margin expansion, which is just as well, given that the corporations have been in cost-cutting mode for the last two years or so. Given the recent deceleration in GDP (from approx. 4% to 3%), and increase in jobs (according to the latest BLS data), one can infer that productivity has decreased. This can be seen in the manufacturing sector in the Industrial capacity utilization, which peaked in Jan ’11 and decreased by 0.1% in February. Capacity utilization is indeed nearing the 40-yr avg.
In fact, sagging corporate profits, a lagging indicator of margin compression in a growing economy, are already telling us the same story. In an environment where Prices are the second-fastest growing component of the PMI, and New Orders and Backlog are the top two fastest slowing components, it is hard to argue that the firms have the ability to pass through price increases in the near future.
Risk Preference: It has been argued that despite poor economic fundamentals, the US market is desirable as it is seen as a safe haven. But, the falling dollar tells a different story. Two additional factors are likely to take away liquidity to foreign shores. First, severe political disagreements over the deficit has exposed the brinkmanship politicians are willing to employ to claim a mandate. With a divided House and Senate, Washington is in a perpetual election mode, more so, now that the presidential campaigns are being announced. Continued divisiveness will drive investors away. Second, central banks across the globe have either already raised interest rates or are about to do so, while Fed has maintained an aggressive accommodative stance with only a few voices such as Kocherlakota suggesting a 50-75bps rise in interest rates. Sticky food inflation will also force developing economies to raise rates faster, simply because of food’s higher contribution to the income basket. In turn, investors will move liquidity to higher-yielding currencies. To sum, unabated safe-haven liquidity is not guaranteed.
Historically, whenever the PMI indices have turned south, the market has declined by 8-10% in the next quarter or so. Consensus is expecting EPS growth of 14.4%, backed by 13% sales growth and margin expansion to 9%; such numbers were last seen during top of the last business cycle (Q1 ’06), and market will be easy to disappoint. I would like to execute this strategy by buying XSP 7/16/11 puts at the strike price of $125. The put is trading at $2.35.