In a Market Full of Questions, Earn Some Safety With This Trade

Earnings season is almost over, and with 92% of the companies in the S&P 500 reporting, results are a little better than expected. About two-thirds of companies beat analysts’ expectations, in line with the long-term average rate. Earnings per share (EPS) came in about 4.9% higher than they were a year ago, the first time we’ve seen year-over-year growth in earnings for two consecutive quarters in two years. 

It seems as if the earnings outlook should be bullish for the stock market based on the growth in EPS, but many analysts are warning that the market is overvalued. Such warnings are often based on charts like the one below, which shows the price-to-earnings (P/E) ratio is higher than average. 

This chart looks back at the past 10 years. Interestingly, to me, the P/E ratio reached its high in the first quarter of 2010, as the stock market was bottoming. Bears were arguing the market was overvalued when it was at the beginning of what would prove to be an extended bull market.

You could argue that the recession was an extraordinary time for the economy and no one could forecast what would happen next. The president, Congress, the Federal Reserve and regulators were all doing what they could to boost the economy.

I would argue those same sentiments apply to 2017. No one knows what will happen next on tax policy, regulation or even interest rate policy. Washington is in turmoil, and upcoming changes could boost earnings, which might make the current P/E ratio of 21.5 look like a bargain.

We know there is talk of a tax cut. Corporate rates could fall from 35% to 20% or even lower. These rumored changes are expected to happen by August, and I believe it will be retroactive to the beginning of the year. A tax cut of that magnitude would raise EPS sharply.

For now, analysts expect EPS of $133.73 for the companies in the S&P 500. To be conservative, we can assume the drastic reduction in taxes increases earnings by just 8%, an amount equal to about one-third the reduction in rates. This would boost earnings to $144 a share.

A decrease in regulatory costs could also increase company’s bottom lines. 

It’s important to remember these changes don’t occur in a vacuum. Real action from Congress should increase consumer sentiment, which would be reflected in higher sales and earnings for large companies. In short, the economy could grow much more than expected this year, and EPS could be much higher than expected when the fourth quarter is actually reported.

Stocks are pricing in higher earnings, and some analysts believe current levels are dangerous, as prices could decline if Congress becomes deadlocked. I see opportunity for now but am watching closely for signs of irrational exuberance in the market.

While I am bullish in the long run, I do believe caution is warranted in the short run. Stocks have moved up quickly since the election, and we’ve had more than two weeks’ worth of consecutive record highs in the Dow Jones Industrial Average. Now is a time for caution, and I want to turn to a trade with a high degree of safety, a short-term put sale in Apple (NASDAQ: AAPL).

I’ve successfully sold puts on AAPL five times since July 2016 for annualized returns of 44.8% 27.4%, 25.7%, 64.3% and even 78.9%. Needless to say, it’s one of my favorite companies to generate income from.
If you want the details of my latest AAPL trade, or would like to learn more about my put selling strategy, follow this link.