One of the Market's Biggest Disconnects Offers Huge Long-Term Potential

With more than half of the companies in the S&P 500 having reported Q3 earnings, it looks like the index will break its five-quarter streak of declining profits. According to FactSet, companies have so far beaten expectations by an average of 6.7% and are expected to post earnings growth of 1.6% over the same quarter last year.

In addition to the potential rebound in corporate earnings, the overall U.S. economy just posted its biggest GDP gain since the end of 2014. The Bureau of Economic Analysis reported last week that GDP jumped 2.9% in the third quarter on an annualized basis.

Yet against this bullish background, the S&P 500 is down more than 4% in the past six weeks. Even more surprising is the fact that one of the standout sectors with regards to earnings is actually down 11% during that time, which makes it one of the biggest disconnects in the market right now.

Near-Sighted Market Punishes Real Estate Sector

Real estate property owners and managers have delivered some of the biggest upside surprises this earnings season, with companies beating estimates by an average of 17.8% so far. The sector is also reporting the highest earnings growth (16%) of all 11 sectors tracked by FactSet.

Among real estate subsectors, residential REITs are leading with expected earnings growth of 89%, followed by health care REITs (51%) and specialized REITs (46%).

This earnings growth is impressive, and it's not just income statement manipulation like stock buybacks that's driving it. Real estate is also reporting the second highest revenue growth among the 11 sectors -- 7.1% on a year-over-year basis. 

So it's odd that real estate has been one of the worst-performing sectors over the past month, as well as of 2016, behind only health care.

Fear of an imminent interest rate hike by the Federal Reserve has weighed on sentiment for the real estate sector. Fed funds futures put the odds of an increase before year end at nearly 72%, and that could mean higher borrowing costs for property owners.

But Fed Chair Janet Yellen and company will likely move extremely slowly with subsequent increases. It's been nearly a year since the last rate hike, and that was the first in nine years. A stronger U.S. dollar has weighed on corporate earnings for more than a year, and rapidly increasing rates would only exacerbate the situation.

As per usual, it seems the near-sighted market has sold off an investment without looking at the long-term picture. Consider that the FTSE NAREIT U.S. Real Estate Index of equity REITs has posted an annualized return of 11.7% over the past two decades.

One of the hardest hit REITs has been Equity Residential (NYSE: EQR), which is down 7% over the past month or so and has fallen 25% year to date. This is in stark contrast to the 12.2% average annualized return over the past 20 years.

Fear of higher interest rates and an increase in apartment building capacity have taken their toll on shares. But Morningstar notes that, while occupancy decreased 20 basis points in the third quarter, the company saw a 3.4% year-over-year increase in sales growth, as well as a 3.4% increase in the average rental rate. And the REIT has been selling off non-core assets to focus on coastal markets that should benefit from faster population growth and favorable demographics for renting.

Equity Residential is a good company in a sector with huge long-term upside potential once real estate fundamentals reassert themselves. However, a December interest rate hike could lead to more weakness in shares before a rebound really takes off, so I want to have a plan in place for that. 

Specifically, I want to purchase shares at these depressed prices while using a strategy that brings in income every few months. This will help protect me on the downside while also providing further incentive to hold shares. 

The way we get these extra benefits is with a covered call.

Generate a 15.1% Yield While You Wait for a Rebound

If you're not familiar with covered calls, then I suggest you watch this 90-second training video. In a nutshell, though, a covered call involves purchasing at least 100 shares of a stock and then selling a call option on that stock to collect income, known as a premium.

Selling a covered call means a few things:

1. By selling a covered call, you agree to sell 100 shares of the underlying stock at a specified price (the strike price) at a specified date (the expiration date) if the stock is trading above the strike price.
 
2. The income you receive for selling the call is yours to keep no matter what.

3. The income lowers your cost basis on the shares and helps protect you if the stock trades lower.

With EQR trading at $61.30 at the time of this writing, we can buy 100 shares and simultaneously sell one EQR Jan 62.50 Call, which is trading around $1.82 ($182 per contract). This lowers our cost basis to $59.48 per share, which is below the stock's 52-week low and gives us about 3% in downside protection.

If the shares close above the $62.50 strike price at expiration on Jan. 20, our shares will be sold for that price. In this case, we will make $1.20 in capital gains plus the $1.82 premium and the December dividend, which is expected to be around $0.50. This gives us a total profit of $3.52 a share for a 5.9% return over our cost basis of $59.48 in less than three months (28% annualized). 

Now, if shares fail to rally above $62.50 at expiration, we get to keep the shares and have the opportunity to sell another call on them. If we could sell a call for about $1.82 every three months, we could earn a total of around $9.28 per share in income in a year, including dividends. That works out to a 15.1% yield, which would certainly keep me happy while I wait for the share price to catch up with the long-term fundamentals.

Covered calls are a great way to earn extra income in a sideways market and protect you against sell-offs in stocks you already own. If you are interested in more ways to implement this strategy in your portfolio -- starting in the next 48 hours -- go here.

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