The S&P 500 Is Going To Enter Correction

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The S&P 500 Earnings Outlook Is Terrible. It’s Not as Bad as It Looks.

Consensus earnings expectations are gloomy this third-quarter earnings season, with S&P 500 earnings forecast to come in 4.3% lower than a year ago. But there’s more to the story behind that headline number.

Layer on the per-share earnings booster of stock buybacks and the change is forecast to come in at 2.3% lower earnings per share. Add companies’ historical tendency to beat earnings expectations, and that decline turns to 1.2% year-over-year growth in EPS. When stock pickers focus on median earnings expectations instead of the market-cap weighted index level, EPS growth could come in at a much healthier 6.2%, according to Credit Suisse chief U.S. equity strategist Jonathan Golub.

“The typical portfolio has a portfolio that looks more like an average group of stocks rather than a cap-weighted group of stocks,” Golub says. “That’s going to look much, much healthier than the index result.”

Fifty S&P 500 companies are expected to report this coming week, including big banks such as JPMorgan Chase (ticker: JPM) and Wells Fargo (WFC). That’s followed by 110 the following week and 114 the week after that. The index posted year-over-year EPS growth of 2.8% in the first quarter, followed by 3.8% in the second quarter. The S&P 500 has returned nearly 19% year to date, with the vast majority of that growth coming from valuation multiple expansion rather than earnings growth.

Of the early batch of S&P 500 companies that had reported third-quarter results through Oct. 7, RBC Capital Markets’ head of U.S. equity strategy Lori Calvasina has observed a higher-than-average rate of earnings beats.

“Beat rates have gotten off to a good start,” Calvasina wrote in a report on Thursday. “So far in 3Q19 reporting season, 86% of the S&P 500 results that have come in have beaten consensus EPS expectations (above 2Q19’s level and well above long-term averages) while 62% have beaten consensus on sales (also a bit above the pace of 2Q19 reporting season, and in line with historical averages).”

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S&P 500 index-level revenue is forecast to have climbed 1.7% year over year for the third quarter, while the median company is expected to grow sales by 3.4%. Much of the drag on sales growth comes from energy companies, which have struggled as the price of oil has dropped precipitously over much of the past year.

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Energy sales are forecast to have declined by 9.6% and their EPS by 33% from a year ago. The slide represents a 1.2 percentage point and 2.0 percentage point drag on S&P 500 revenue and EPS, respectively.

Although analysts expect financials earnings to decline 2.5% from the third quarter of 2020, hefty buybacks are forecast to push that decline to 2.5% growth in EPS. Other expected EPS growers include health care, real-estate investment trusts (REITs), and utilities at 2.6%, 2.3%, and 2.2%, respectively. Those are the only three sectors that have seen positive earnings revisions trends—meaning more upward than downward revisions—heading into this earnings season, according to Calvasina.

Golub notes that after the third and fourth quarters of 2020, expectations are for earnings to rise more strongly in 2020.

“I don’t believe the market is going to respond as badly to weak earnings numbers because they’re perceived correctly or incorrectly to be somewhat temporary,” he says.

The 2020 full-year S&P 500 earnings consensus estimate is currently $164, forecast to increase 10% to $181 next year. Calvasina notes that the typical downward revision could push that down to $175.

Raymond James institutional equity strategist Tavis McCourt isn’t optimistic about those 2020 numbers.

“Having been an analyst, it is pretty clear what is happening with 2020 earnings expectations,” he wrote in a recent report. “Analysts appear to be broadly looking for a return to normal in the trade war as cyclical sector earnings are expected to bounce back heroically. Although always a possibility, especially with trade war relief, it is clear the buy side doesn’t believe this given where cyclical valuations are currently.”

4 Strategies to Short the S&P 500 Index (SPY)

Since the stock market trends higher or stays level far more often than it declines, it is difficult to make consistent money by shorting stocks or exchange-traded funds (ETFs). You can sell short S&P 500 ETFs like SPY, but this strategy can be risky since losses on short positions in stocks, ETFs or stock index futures are potentially unlimited, and may be subject to margin calls. However, there are times when a bearish bet against a benchmark stock index such as the S&P 500 is appropriate, and there are several reasonable methods available.

Key Takeaways

  • Most investors know that owning the S&P 500 index is a good way to diversify your equity holdings since it contains a broad swath of the stock market.
  • But sometimes, investors or traders may want to speculate that the stock market will broadly decline and so will want to take a short position.
  • A short position in the index can be made in several ways, from selling short an S&P 500 ETF to buying put options on the index, to selling futures.

Inverse S&P 500 ETFs

By utilizing the SPDR S&P 500 ETF (NYSEARCA: SPY), investors have a straightforward way to bet on a decline in the S&P 500 Index. An investor engages in a short sale by first borrowing the security from the broker with the intent of later buying it back at a lower price and closing out the trade with a profit. The S&P 500 ETF is huge, liquid and closely tracks its S&P 500 benchmark. Hedge funds, mutual funds and retail investors all engage in shorting the ETF either for hedging or to make a direct bet on a possible decline in the S&P 500 Index.

But if you don’t want to sell the ETF short, you can instead go long (i.e. buy) an inverse ETF that goes up when the underlying index goes down. For example SPDN is the Direxion Daily S&P 500 Bear ETF that is designed to provide 1x inverse exposure to one of the most popular indexes among investors.

There are also several leveraged short ETFs with the objective of returning twice or 3x the inverse return of the S&P 500, but be aware they have much more trouble hitting their benchmark. This slippage or drift occurs based on the effects of compounding, sudden excessive volatility and other factors. The longer these ETFs are held, the larger the discrepancy from their target.

Inverse S&P 500 Mutual Funds

Inverse mutual funds, known as bear funds, also seek investment results that match the inverse performance of the S&P 500 Index after fees and expenses. The Rydex and ProFunds mutual fund families have a long and reputable history of providing returns that closely match their benchmark index, but they only purport to hit their benchmark on a daily basis due to slippage.

Similar to the inverse leveraged ETFs, leveraged mutual funds experience a bigger drift from their benchmark target. This is particularly true when a fund leverages up to three times the inverse return of the S&P 500. The Direxion fund family is one of the few employing this type of leverage.

Inverse mutual funds engage in short sales of securities included in the underlying index and employ derivative instruments including futures and options. A big advantage of the inverse mutual fund compared to directly shorting SPY is lower upfront fees. Many of these funds are no-load and investors can avoid brokerage fees by buying directly from the fund and avoiding mutual fund distributors.

Put Options

Another consideration for making a bearish bet on the S&P 500 is buying a put option on the S&P 500 ETF. An investor could also buy puts directly on the S&P 500 Index itself, but there are disadvantages to this, including liquidity. Staying with the ETF is a better bet based on the depth of its strike prices and maturities. In contrast to shorting, a put option gives the right to sell 100 shares of a security at a specified price by a specified date. That specified price is known as the strike price and the specified date as the expiration date. The put buyer expects the S&P 500 ETF to go down in price, and the put gives the investor the right to “put,” or sell, the security to someone else.

In practice, most options are not exercised before expiration and can be closed out at a profit or loss at any time prior to that date. Options are wonderful instruments in many ways. For example, there is a fixed and limited potential loss. Moreover, an option’s leverage reduces the amount of capital to tie up in a bearish position. However, remember the Wall Street aphorism that says the favorite strategy of retail options traders is watching their options expire worthless at expiration. One rule of thumb is, if the amount of premium paid for an option loses half its value, it should be sold because, in all likelihood, it will expire worthless.

Index Futures

A futures contract is an agreement to buy or sell a financial instrument, such as the S&P 500 Index, at a designated future date and at a designated price. As with futures in agriculture, metals, oil and other commodities, an investor is required to only put up a fraction of the S&P 500 contract value. The Chicago Mercantile Exchange (CME) calls this “margin,” but it is unlike the margin in stock trading. There is huge leverage in an S&P 500 futures contract, and a short position in a market that suddenly starts to ascend can quickly lead to large losses and a request from the exchange to provide more capital to keep the position open. It is a mistake to add money to a losing futures position, and investors should have a stop-loss on every trade.

There are two sizes of S&P 500 futures contracts. The most popular is the smaller contract, known as the “E-mini.” It is valued at 50 times the level of the S&P 500 Index. The large contract is valued at 250 times the value of the S&P 500, and volume in the smaller version dwarfs its big brother. Small traders quickly gravitated to the E-mini, but so did hedge funds and other larger speculators, because this contract trades electronically for more hours and with greater liquidity than the large contract. The latter contract still trades on the floor of the CME in the traditional open outcry method. To limit risk, investors can also buy put options on the futures contract rather than shorting it.

The Bottom Line

When bear markets arrive, shorting individual stocks can be risky and hard the best stocks to short hard to identify. Just as owning the S&P 500 index in a bull market provides less volatility and diversification, shorting the index during a bear market can provide similar benefits to a bearish investor. Here, we go over some effective ways of gaining short exposure to the index without having to short stocks.

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