Wall Street’s disappointment with Q3 earnings season has been insightfully captured by the following graphic put out by Bespoke Investment Group yesterday, which shows the average one-day percentage change on earnings report days since Alcoa (NYSE:AA) kicked off the earnings deluge earlier this month:
Two troubling themes stand out:
First, the average return for S&P 500 stocks in every sector highlighted has been negative. Not a one has been able to eke out an average gain following earnings reports.
Second, stocks outside of the S&P 500 club have performed notably better than their blue-chip brethren. Of course, if you own small- or mid-cap stocks, this actually might have worked to your favor. Still, it’s is a worrisome development. As Bespoke notes, only 250 stocks have reported earnings thus far, so we’ve got a ways to go until the earnings party comes to a close. Whether the reactions improve or worsen remains to be seen.
In light of this troubling earnings trend, traders might want to look at playing the more defensive areas of the market, such as utilities, consumer staples and health care. These risk-off sectors typically exhibit less volatility as well as outperform during market downturns.
Let’s zero in on the utility space, which has held up quite well in recent weeks.
Of the nine Select Sector SPDRs, the Select Sector Utility SPDR (NYSE:XLU) — holder of Duke Energy (NYSE:DUK), Southern Co. (NYSE:SO) and the like — currently boasts the lowest 21-day historical volatility at 8%.
In the amusement park of Wall Street, the utility sector is the kiddie coaster — designed to please participants with the least amount of risk tolerance. Although it won’t deliver outsized returns in a short period of time, it also won’t get bludgeoned to death during a steep market correction.
What the utilities lack in price performance, they make up for in dividend yield, which currently stands at 3.92%. This is obviously an attractive quality for longer-term investors.
Click to Enlarge The price chart of XLU has weathered the tumultuous market of late like a champ. XLU has established a short-term uptrend and climbed back above its 50-day moving average. The current pullback might be providing a low-risk entry point if it can hold the rising trendline highlighted in the accompanying chart.
The cheap price tag of XLU coupled with its low volatility make it difficult to structure an attractive option spread position. Buying shares of XLU actually might not be a bad way to go here.
If I were inclined to take the options route, though, I would suggest buying the December 36-37 bull call spread for 57 cents or better. The max risk is limited to the initial 57-cent debit paid at trade entry and will be incurred if XLU sits below $36 at expiration. The max reward is capped at 43 cents and will be captured if XLU sits above $37 at expiration.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.