At the start of the third-quarter earnings season, let it be said that investors are nervous, analysts are generally worried about earnings growth, and the options market is a cauldron of coiled anxiety.
The cause for this sour sentiment? Expectations that the Federal Reserve may soon raise interest rates, for a variety of reasons.
The economy is beset by inflationary pressures. Supply chains are struggling to keep pace with consumer and corporate demand for everything from semiconductors to toilet paper. Economic growth, which ultimately drives corporate earnings, appears to be slowing, and that generally portends poorly for stock prices. The drama in Washington over raising the debt ceiling, and dueling legislative agendas, adds a circus-like air to the market.
What is less discussed is that the rules of the game are changing. When the Fed finally raises interest rates, most investors will have to learn some new tricks.
After 20 years of easy-money policies, investors have come to rely on the mighty “Fed put”—the belief that the Fed will do whatever it takes to keep the stock market from falling too far. Now, it seems the Fed put might expire after this earnings season, and making money in the stock and options markets may no longer be so easy.
The good news? There are ways to monetize these unusual conditions during an event-heavy calendar.
There are many crosscurrents moving above and below the market’s surface. The S&P 500 index is dancing around historic highs. Yet earnings estimates for the third quarter show little expectation that corporate earnings reports will prove to be much of anything—and this could create some opportunities for aggressive investors.
John Marshall, Goldman Sachs ’ derivatives strategist, recently advised clients that analyst estimates for the third quarter have been revised upward by 12% over the past three months but still remain 2% below the second-quarter’s level (not including the financial sector).
Meanwhile, single-stock skew—the difference between bearish put-option and bullish call-option implied volatility—is at the highest level in over a year.
The elevated skew suggests that investors have bought bearish puts to hedge earnings reports, thus creating conditions that could spark relief rallies in certain stocks on earnings day, and even in broad indexes, Marshall told clients. Investors are so pessimistic about corporate earnings—and have positioned that way in the options market—that any bit of good news could prompt strong moves in individual stocks.
To trade these conditions, Marshall has assembled a list of stocks in which Goldman analysts are the most out of consensus with the Street view. On stocks that have the potential to beat earnings estimates, he has suggested that clients consider buying calls that expire in one month, with strike prices just above the current stock price.
Goldman’s trading menu for stocks with potential upside to earnings estimates includes Starbucks (ticker: SBUX), Canadian Natural Resources (CNQ), YETI Holdings (YETI), Cenovus Energy (CVE), Carlyle Group (CG), Signature Bank (SBNY), Align Technology (ALGN), Maravai LifeSciences Holdings (MRVI), Fortune Brands Home & Security (FBHS), Shoals Technologies Group (SHLS), CF Industries (CF), Okta (OKTA), Playtika Holding (PLTK), and Republic Services (RSG).
At a time when so many investors are confused about what to do, Goldman’s approach shows how a sophisticated strategist is thinking when change is in the air and investors are nervous about what comes next.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.