The stock market took a beating on Monday. The S&P 500 Index fell 1.6% while the Dow Jones Industrial Average lost 2.1%. The culprit was mounting concern over the Delta variant of COVID-19. During the past month, the seven-day moving average of the daily case count for the virus has tripled in the United States.
Last week, Los Angeles County reimposed a mask mandate for all indoor activities. That order affects everyone, including people already vaccinated for the virus. If more municipalities follow suit, it may only be a matter of time until severe social distancing restrictions once again impede economic growth in this country.
As I noted a few days ago, that concern is already visible in travel companies that are especially vulnerable to the virus such as cruise ship operator Carnival (NYSE: CCL). Now, it is beginning to spread to the leisure and entertainment industry.
On June 9, the Invesco Dynamic Leisure and Entertainment ETF (NYSE: PEJ) crested above $54. That is about the same time that the daily case count for COVID-19 in the U.S. started to rise.
By the beginning of this week, it had gradually receded below $48. That’s a decline of more than 12% in only six weeks. Over the same span, the SPDR S&P 500 ETF Trust (SPY) was up less than 1%.
Based on just those numbers, you might think that investors are overreacting to the threat posed by the Delta variant. However, even after its recent decline PEJ was still up more than 18% this year.
Don’t Buy the SPY
I am often asked what is the best way to hedge a stock portfolio against another outbreak of COVID-19 that shuts down the global economy. The obvious answer is to buy put options on SPY (a put option increases in value when the price of the underlying security goes down).
Since it mirrors the movements of the S&P 500 Index, SPY is the best proxy for the U.S. stock market. At the start of this week, the SPY put option that expires on December 17 at its current price could be bought at a 5.6% premium.
For that trade to be profitable, SPY would need to fall nearly 6% within the next five months. Quite frankly, I will be surprised if that does not happen.
And if that happens due to a resurgence of COVID-19, odds are that PEJ will drop a lot more than that. If the options market is to be trusted, leisure and entertainment stocks could be down twice as much as the index.
At the start of this week, the PEJ put option that expires on December 17 at its current value could be bought for an 11.2 % premium. That is precisely double the options premium for taking an equivalent position in SPY.
I do not advise paying that high of a premium for put options on PEJ. The spread between the bid and offer prices for those options is extremely wide. I’d wait a few weeks to see if that spread narrows.
Wait for the Big Four
The top five holdings in PEJ are Starbucks (NSDQ: SBUX), Walt Disney (NYSE: DIS), ViacomCBS (NSDQ: VIAC), McDonald’s (NYSE: MCD), and Yum China Holdings (NYSE: YUMC). Combined, they account for more than 20% of the fund’s total assets.
Those four companies are scheduled to release their quarterly results over the next three weeks. I expect all of them to report strong Q2 results compared to last year. I also expect them to downplay the potential threat to their businesses posed by the Delta variant of COVID-19 in their guidance for the remainder of this year.
If so, then that may be the optimal time to buy put options on PEJ. The premiums on those options should drop as the stock market rallies on those results.
However, third quarter results could be a very different story. Some businesses are demanding that their employees stop working from home after Labor Day and start coming into the office. Kids will be back in school and sports stadiums will be full.
That’s when our population will be most vulnerable to a resurgence of COVID-19. And if a major outbreak does occur, the leisure and entertainment industry will feel the pain first. That may only be a minor drag on the overall market but it could send those stocks tumbling.
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