August 17, 2015
This Hedge Could Land
Traders 75% -- If They Act Now
By Joseph Hogue
With the vast majority of companies in the S&P 500 having reported earnings, it appears the index will post the first earnings decline since Q3 2012. Worse still, we will likely see the first back-to-back quarters of revenue decline since 2009, with Q2 sales estimated to drop 3.3%.
On top of that, slowing Chinese economic growth and fears of an imminent U.S. interest rate hike are putting the market on edge.
While I think there is still a lot of value left in the market, especially in some beaten-down sectors, it looks like the end of the six-year bull market is near. So while I will continue to let my long positions run for now, I also want to gain short-side exposure to companies that could be hard hit by any economic weakness. The particular company I have in mind is intimately exposed to employment trends.
Employment Signaling Economic Weakness to Come?
While the rest of the market likes to fixate on the monthly jobs report, I follow the weekly initial unemployment claims for insight into the health of the labor market.
Weekly initial jobless claims of 255,000 in late July were the lowest in 41 years. While the most recent Labor Department report showed a bump to 274,000, jobless claims have remained below 300,000 for 23 consecutive weeks. Going back four decades, the labor market has weakened quickly once initial claims dropped below 300,000.
Revenue declines may lead corporations to cut employees in a last-ditch effort to shore up earnings, especially considering businesses are likely already looking toward the possibility of higher interest rates as a warning of economic headwinds. Research shows a lag of about six months to a year for rate hikes to affect economic growth, meaning a September or December increase could lower economic growth as early as the second quarter of next year.
As I mentioned, there is a company that could be hard hit by economic weakness, especially weakening employment.
Aramark (NYSE: ARMK) provides food, facilities and uniform services to clients in the education, health care, business, sports, leisure and corrections industries. Nearly 70% of the company's sales come from North American food service, with another 21% from international contracts. The uniform rental industry accounts for 10% of sales.
Aramark makes much of its money by managing corporate cafeterias. While the company holds long-term contracts on its food service facilities business, 70% of that revenue is through profit-and-loss contracts. This means Aramark doesn't get a fee for managing the facilities but makes its money on food sales through the service.
These sales could suffer if the economy or employment turns lower with fewer employees buying food and the remaining employees likely spending less. This would make these long-term contracts an albatross on profitability. This is especially worrisome since the operating margin on the company's food service business is already just 5.7% -- well below the industry leader's 7.1% margin.
Shares are up 44% from their December 2013 IPO. That marked the company's third debut as a publicly traded company, as it was acquired by management and private equity groups twice before. Nearly half of ARMK shares are still held by five private equity and investment firms. These firms could be looking to unload their positions after the run up in the stock before economic weakness hits sales.
It's important to note that the company is classified as a "controlled company" by the NYSE, meaning it doesn't have to comply with some corporate governance standards that protect shareholders.
All this translates to one of the best hedges against coming market weakness.
Turn an 11% Stock Move Into a 75% Profit
I'm not calling an end to the bull market just yet, but the potential for labor market weakness and rate-induced economic headwinds has me on edge. It could be a year before the market corrects... or it could be a few months.
Any weakness in employment would hit Aramark directly through its food service and uniform rental contracts. There is also the potential for selling by the private equity and investment firms that still control the company.
With ARMK trading for $32.71, we can look to buy the ARMK Jan 35 Puts for $3.45 or less. That is a put option with a $35 strike price that expires on Jan. 15. Each contract controls 100 shares, costing you $345 per contract.
The trade breaks even at $31.55 ($35 strike price minus $3.45 options premium), which is 3.6% below the current price.
The January expiration means we can benefit from the potential for both the September and December Federal Reserve meetings to put the market on edge, as well as any labor market or other economic weakness.
I believe this could push shares down 11% to $28.95 by the time this option expires. If my target is hit, the option will be worth $6.05, resulting in a gain of 75% in five months. Place a good 'til cancelled (GTC) order to exit at this price.
Put options are the absolute best way to play the downside in stocks and hedge against general market weakness. They offer outsized gains while taking on less risk than shorting a stock outright. In just the past month, this strategy has returned 39% in seven days and 69% in nine days. That's an annualized return of more than 2,000% per trade.
The trader who recommended these options is a self-made millionaire with a strategy that's averaging an annualized 123% per trade. These kinds of returns could help save your portfolio when the market takes a turn for the worse. Follow this link to find out how you could join in the profits today.
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