BANK OF AMERICA: The stocks outshining the market's powerful rally are poised for a sharp reversal - but there's a way to avoid the losses ahead
- High-beta stocks that typically beat the broader market during rallies outperformed their low-beta counterparts to a nearly unprecedented degree during the first quarter, according to derivatives strategists at Bank of America Merrill Lynch.
- This trend is not likely to continue in the months ahead, they said.
- The BAML analysts identify a sector that mirrored the high-beta/low-beta dynamic in the first quarter, and provide a trading recommendation to profit from a market reversal.
With one of the stock market's best first quarters fully in the rear-view mirror, Wall Street is drawing some interesting conclusions about the action.
The S&P 500 gained 13% last quarter for its ninth-best start to a year in history, and high-beta stocks joined in the party. This cohort - which consists of equities that are more volatile than the S&P 500 and tend to beat its gains - recorded "one of its largest outperfomances" versus low-beta stocks that move in closer lockstep with their benchmark, according to Bank of America Merrill Lynch.
To that end, the BAML analysts singled out one sector that mirrors the trends in both very closely: biotech.
One of the distinctive attributes of some biotech companies is their reliance on a very small and perhaps even singular product pipeline. A company can spend years developing a new, potentially lifesaving drug, only to have it fail a latter phase of the Food and Drug Administration's approval process. This makes biotech stocks susceptible to violent moves.
But not all biotech stocks are faced with such binary outcomes, and two of the biggest exchange-traded funds that track the sector reflect as much, according to BAML. The iShares Nasdaq Biotechnology ETF (IBB) represents the less volatile, low-beta equivalent because its biggest components - including Amgen and Gilead Sciences - rely less on single-drug approvals for their businesses and stock performance.
Conversely, the SPDR S&P Biotech ETF (XBI) displays more volatility, like high-beta stocks.
Just as high-beta stocks crushed low-volatility stocks in the first quarter, XBI saw a near-record outperformance over IBB, as the chart below shows.
However, this trend is likely to reverse in the coming months, according to BAML.
"History suggests that while S&P is likely to continue rallying from here, high beta will not continue to outperform to the same degree," said Chintan Kotecha, an analyst at BAML, in a note to clients.
He continued: "Indeed, subsequent 3m S&P returns were positive 72% of the time whenever high beta stocks outperformed low volatility stocks by similar levels as now (~7.5% or more, corresponding to the 80th %-ile). However, when indeed subsequent S&P returns were positive, the 3m return differential between high beta vs. low volatility stocks was lower 88% of the time and on average only 0.2x as large."
The same up-then-down pattern has historically occurred within the biotech sector, and provides a way for traders to profit from a likely slowdown in high-beta stocks, Kotecha said.
Kotecha recommended selling XBI call options - or bets that the ETF will rally - and using the proceeds to buy call options on IBB.
"To monetize a slowing and/or reversal of the high-beta stock relative performance, we recommend levering the XBI/IBB vol differential by selling XBI calls to help fund IBB calls," he said. For instance, selling 0.8x XBI Jun19 94 calls (ref. 91.27) fully funds 1.0x IBB Jun19 115 calls (ref. 112.47) (in both cases, 44-delta calls)."