Time to Take Profits in GEO Group as Trump Trade Is Overbought

Equities have reacted with a huge amount of exuberance to the results from Tuesday’s U.S. presidential election. It was a decisive and clear result, which took prospects of weeks of potential election litigation off the table and provided much needed clarity to the market. Not surprisingly, the market has had quite the euphoric rally this week, and the Federal Reserve cut interest rates by another 25 BPS on Thursday, as expected, to put the cherry on top of that sundae.

The big equity rise has pushed the S&P 500 further into uncharted territory by many valuation metrics, including the price-to-sales ratio as well as the overall market-cap-to-U.S.-GDP ratio. The United States has approximately 5% of the global population, but the S&P 500 now represents just over half of all equity value worldwide. Something that is unlikely to hold over the longer term.

Small caps have staged a huge move up, with the small-cap Russell 2000 rising more than 7% from where it was at on election eve. This makes sense on several fronts. At the beginning of November, the Russell 2000 had delivered roughly half the return of the S&P 500 year to date. Small caps were overdue for some sector rotation, especially as tax loss selling by fund managers ebbed. Smaller companies should also benefit from the lighter hand of the new administration around taxes and regulations.

Some of the "Trump trades" have clearly overshot at this point, however. Take the stocks of prison operators, for example. I own a good chunk of The GEO Group GEO within covered-call orders, but the roughly 75% move up this week makes this equity quite overbought. Does anyone really think the U.S. is going to go on a huge private prison binge to enable mass incarceration or deportation? I would be taking some profits in these names, if they are in your portfolio.

Nor does the election even begin to address the 800-pound gorilla in the room. That is the huge debt overhang out there. Investors continue to remain much too complacent about this threat, as does the general public. Don’t believe me? Next time you are out at a social event or gathering and have struck up a conversation, ask the person you are talking to what the annual interest tab on the federal debt would be at the current yield on the 10-year treasury. Trust me, you will get a half dozen blank stares for every guess that is somewhat in the ballpark. The correct answer current is approximately $1.6 trillion, larger than the biggest line item in the budget for Medicare.

Since the first cut to the fed funds rate in mid-September, the yield on the 10-year treasury has moved up some 70 BPS. This isn’t helping the commercial real estate sector, which is in increasingly-dire shape. The default rate on commercial mortgage-backed securities for both retail and office properties is in the high single digits and still moving consistently higher. And this does not account for loans where only the interest is being paid.

With yields on the short end of the treasury curve moving down, I am shuttling more of these funds into the market within my portfolio. That seems a contradictory move given my overall view of the market. And it is, but with one giant caveat. I am doing so using covered-call orders around stocks that I still believe sport somewhat reasonable valuations. In addition, I am moving down the strike prices on the selected option I utilize to execute these covered-call positions. So, if a stock is selling at $20.50 a share, instead of using an option with a strike price of $20, I am choosing the $17.50 strike price. This lessens my potential return, but also provides substantially more downside protection.

In my column next Monday, I will highlight two biotech stocks that have been successful "rinse, wash and repeat" covered-call trades in my portfolio for years. Both companies reported stellar third quarter results late this week.

At the time of publication, Jensen was long GEO.