Emotions are part of the stock market. Analysts warn of greed and fear, two emotions that can blind investors to the fundamentals of the market. At tops, we tend to see investors acting with greed while at bottoms fear seems to become the dominant emotion.
Knowing this, investors can watch for signs of emotions in their own responses. When they see signs of a market bubble forming, for example, they can monitor themselves for signs of greed. This might include ignoring fundamentals or watching technicals deteriorate and wanting to invest anyway.
At bottoms, investors need to watch for signs of fear. The decision to sell everything will almost never be the correct answer. However, that is a problem at market bottoms as losses mount and investor frustration grows. Avoiding that reaction can help investors make money when prices rebound.
These simple examples illustrate that awareness of emotional traps can help investors avoid these problems in their own accounts. But, greed and fear are not the only emotional responses of investors. Feelings of love and hate are also found in the stock market.
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Love and hate often play out within sectors although there are times when the emotions affect the prices of individual stocks. Right now, for example, it seems investors love Facebook, Apple, Amazon.com, Netflix and Alphabet, the parent of Google. These are the FAANG stocks and they are leading the market as investors demand exposure to the stocks.
Sectors and Emotions
The FAANG stocks seem to show that investors love tech stocks, for now. But, there are also some sectors that investors seem to hate. Retail is one sector that many analysts say should be avoided and it seems to safe to say the sector is among the most hated in the market right now.
In part, it could be that Investors’ love of Amazon.com is responsible for some of the hate of retail stocks. Amazon’s success is taking some sales away from traditional retail stores. Enough retailers are now suffering that the entire sector is at risk.
The chart below shows the trend in the sector. This is a long term, monthly chart of the SPDR S&P Retail ETF (NYSE: XRT), an ETF that tracks the broad sector. The ETF’s holdings include Sears Holdings Corp (Nasadq: SHLD), J. C. Penney Company, Inc. (NYSE: JCP) and Best Buy (NYSE: BBY).
XRT has been trending lower since 2014, in line with the long term trends in the retail sector. But, the ETF is just over 20% below its highs, a bear market but not a catastrophic collapse. However, some of the ETF’s holdings have suffered catastrophic declines. One example is Sears.
While the sector is broadly hated, investors tend to be responding in one of two ways.
Some investors are selling retailers and avoiding the sector. They see the headlines about the demise of the shopping mall, the rise of Amazon and its recent purchase of Whole Foods Markets (NYSE: WFM) and continued slow growth of the economy. They believe traditional retailers face nearly insurmountable challenges and are sidestepping the sector while pursuing better opportunities.
Other investors are bargain hunting. They believe the sector is in trouble but do not believe the entire sector will fail. Thy may concede there have been a large number of bankruptcies but they believe this increases the potential strength of the sector’s survivors.
While some investors call this type of behavior, others refer to it as an attempt to catch a falling knife. They point out that catching a falling knife is possible but it is unlikely to be a successful endeavor. More often than not, the attempted catch leads to an injury. Investors can think of injuries as losses.
Which Is It – A Value Play or A Falling Knife?
It seems clear that hated sectors are either one or the other. The stocks in these sectors could be value investments which will deliver large returns in time. Or, the stocks could be on their way to zero as the industry shakeout continues and claims more victims. The challenge for investors is determining which is which.
To make this decision, it may be best to ignore emotions. We know from numerous studies that stock prices tend to move in trends. To be more specific, for periods of time measured in months to a few years, prices tend to trend. In the very short run and in the very long run, prices tend to exhibit mean reverting behavior.
Retailers, as chart of XRT shows, have been weak but they have not exhibited a strong down trend. In other words, the largest losses likely lie ahead for the sector. There will be some winners but there will be time to find them after the up trend begins.
That chart of XRT shows there is no need to rush the hunt for bargains. The ETF delivered a total return of more than 650% in the bull market that peaked in 2014. There was plenty of time for investors to make money in the sector after the trend developed.
In the short term, it is best to assume that the weakness in the sector will continue. That means traders should bet on further declines rather than trying to find a bottom. They can either ignore the sector for now or they could utilize strategies that benefit from declines.
Specific Trading Strategy for Retailers
To benefit from the expected weakness, traders can look at individual stocks within the retail sector or they can trade XRT which tracks the broad sector. For traders looking for large gains, individual stocks could work best. For those seeking steady gains, XRT provides opportunities.
The daily chart shown below shows that XRT is in a short term downtrend.
XRT closed on Monday at $38.75. One way to trade a down trend is to buy a put option. The problem with this strategy is that it can be expensive. A December $40 put option on XRT is trading at $2.77. This option needs a significant move before the trade can even break even.
A less expensive strategy with less risk is to use a call spread with options that expire within a relatively short amount of time. There are call options expiring on August 4 that could be used with this strategy.
To open the trade, a trader would sell an August 4 $40 call which is trading at about $0.29 and buy an August 4 $41.50 call for about $0.05. Each contract represents 100 shares so the $40 call would generate a credit of $29 and the $41.50 call would cost $5, before commissions which are a small amount at a deep discount broker. This trade would result in a credit of $24.
To open the trade, brokers will generally require a margin deposit equal to the amount risked. In this case, the risk is equal to the difference in the strike prices ($150) less the credit received ($24) or $126.
This trade offers a high potential reward of more than 20%. The potential gain can be found by dividing the amount of premium received by the amount of trading capital risked. This is a short term trade, lasting just three weeks.
Traders can open similar trades in XRT each time the option spread expires. In this way, they can compound gains as long as the trend is down. When the trend reverses, they can then trade on the up side.
However, until the trend clearly reverses, it could be best to use bearish strategies with XRT and with individual retailers. There is ample time to benefit from the up trend when it begins. Following the trend also allows for profits on the down side.