CORRECTED-HOW TO PLAY IT: Getting defensive before earnings season
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CORRECTED-HOW TO PLAY IT: Getting defensive before earnings season   | 10.04.2012.

NEW YORK, April 10 (Reuters) - The market rally that few expected in the first place may finally be slowing down.
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By David K. Randall

NEW YORK, April 10 (Reuters) - The market rally that few expected in the first place may finally be slowing down.

The benchmark Standard & Poor's 500 index jumped 12 percent in the first three months of 2012. Some of the worst performing investments of 2011 led the market's march higher. Financial companies gained 21 pe rcent over the first quarter. The Russell 2000 index of smaller companies rose 12 p er cent.

But few analysts are predicting that these gains will continue. That is in large part because the earnings season that begins Tuesday when Alcoa reports after the bell is expected to be lackluster.

Earnings of the companies in the S&P 500 index are expected to grow 3.2 percent in the first quarter of 2012 compared to 9.2 percent earnings growth in the final quarter of 2011, according to Thomson Reuters data. High gas prices, meanwhile, could cut into business and consumer spending, further weakening earnings growth later in the year.

Taken together, this could be a good time for caution. Here are suggestions for playing this earnings season defensively.


Some investors are looking for stability over risk as the next earnings season unfolds.

"I'm making sure that I'm hedged every place that I'm long that I can," said Uri Landesman, president of Platinum Partners, an investment firm in New York.

Landesman expects non-cyclical sectors like utilities, consumer staples and health care to outperform over the next three months, a period over which he forecasts the S&P 500 index will fall to 1,290, or about 8 percent. The index closed at 1,398 Thursday before the Good Friday holiday and fell about 16 points, or 1.1 percent, on Monday.

So-called defensive sectors typically have stable revenues and offer above-average dividend payments to investors. These sectors have lagged the market this year. Consumer staples companies, for instance have gained about 4 percent since the year began. That lack of investor enthusiasm could help defensive sectors outperform over the next quarter as valuations increase, analysts said.

The $810 million Vanguard Health Care ETF offers one option. The fund, which costs 19 cents per $100 invested, is up about 10 percent in 2012, or about one percentage point below the broad S&P 500 index, and pays a dividend of nearly 2.9 percent. Johnson & Johnson, Pfizer and Merck & Co account for nearly 30 percent of assets.

The iShares S&P Global Consumers Staples ETF is appealing because it holds mega-cap firms and includes international stocks that may offer higher yields than U.S. companies, noted Robert Goldsborough, an analyst at Morningstar. The $464 million fund, which costs 48 cents per $100 invested, offers a yield of 2.2 percent. Nestle, Procter & Gamble and Coca-Cola are its top holdings. The fund is up 6 percent this year, giving it a better value tilt than the health care sector, despite its lower dividend yield.

Randy Frederick, a managing director of active trading and derivatives at Charles Schwab, suggests investors look to the options market to limit their risks. He recommends a collar option strategy, which involves purchasing an out-of-the-money put option on an S&P 500 ETF like State Street's SPY while simultaneously writing an out-of-the-money call option.

This strategy would allow an investor to maintain long positions in the S&P 500 without worrying about short-term declines, he noted. He expects the S&P 500 to fall to around 1,340, or about 6 percent below the high of 1,422 reached last week.


A slow earnings season may offer opportunities to go long on certain stocks and sectors at attractive prices.

Phil Orlando, chief market strategist at Federated Investors, also expects the broad S&P 500 index to fall to 1,340 by the end of the quarter.

"We were overdue for a correction, and we're probably about half of the way there," he said. But the declining prices may have a silver lining, he said. "This is an opportunity, particularly for investors who have missed this rally over the past 6 months."

Orlando is particularly bullish on banks, despite their broad gains this year, because they would likely benefit from the growing economy and any strengthening in the real estate market. The $766 million Vanguard Financials ETF is one low-cost option. It charges 23 cents per $100 invested and yields 1.7 percent. Wells Fargo, JPMorgan Chase and Citigroup collectively account for about 15 percent of the fund's holdings.

Vadim Zlotnikov, meanwhile, is looking for technology firms to outperform, in large part because their margins are expected to expand more than the overall market by about 5 percentage points. Large-cap software companies which have lagged the broad market and whose low valuations are "encouraging for future returns," are among those he points to.

Zlotnikov recommends defensive software companies like Microsoft, Intel and Cisco because of their attractive cash flows and low valuations. Microsoft, for instance, trades at a price to earnings ratio of 11.4, compared with a 14 ratio for the broad S&P 500. The company pays a dividend of 2.5 percent, and has some momentum in its favor. Shares are about $1.50 below the 52-week high of $32.95 they reached in mid-March, and are up 21 percent so far this year.

Falling out of favor for Zlotnikov: growth companies with high valuations and decelerating earnings growth like F5 Networks, VMWare and Red Hat. VMWare, for instance, is seeing sales growth of 32 percent year over year, compared with a 41 percent growth rate 12 months ago.

The company trades at a P/E of 67 and is up 36 percent this year. It reports earnings on April 18.

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