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Are you ready for a market slowdown or potentially lower returns going forward?
The S&P 500 index, as seen through its proxy SPDR S&P 500 ETF (NYSEArca: SPY), is up roughly 3.5% so far this year. Of course, this is on top of what has been a six-year bull market that has extended gains well over 170% during that period.
We must be realists and ask ourselves, is the market cheap at current levels? Remember, our job as investors is to buy low and sell high. But during extended bull markets we often forget this simple rule as greed replaces logic. For it is greed that leads to devastating losses.
Just look at Prof. Robert Shiller’s cyclically adjusted price-earnings ratio, which compares the price of the S&P 500 to the index’s trailing 10-year average earnings, adjusted for inflation.
Based on his data, the Nobel Prize winner in economics shows in the chart above that at 27.85 times earnings the market is currently at a level where previous bull markets have struggled to move higher.
Shiller’s data also shows that current valuations only appear cheap when compared to the tech bubble in 2000. Moreover, his research shows that only recently earnings exceeded pre-financial crisis levels.
Realistically, do we think the market is going to repeat its performance from several years ago, when the S&P 500 rallied 32.4% in one calendar year? I certainly don’t, not at this stage of the current bull market.
Markets are not cheap by any measure. If earnings growth continues to wane or interest rates rise, the bull market thesis will collapse as “expectations” collide with “reality.” This is not a dire prediction of doom and gloom, nor is it a “bearish” forecast. It is just a function of how markets work over time.
I think we are going to see more of what we are currently witnessing: a range-bound market that ultimately leads to a bear market. I’m not saying a crash is going to occur, but I do think fear will enter back into the market sooner than later and as a seller of options, I welcome its return.
Profiting from Fear
An increase in market fear means an increase in implied volatility, and an increase in volatility leads to higher options prices.
Ultimately, as an options seller I really don’t care where the market is headed, as long as implied volatility is above historic levels. In 2013, those of us who sell options for a living struggled as implied volatility was at historic lows. But the 30% gain in the S&P 500 in 2013 was an anomaly, something that we need to recognize when we think about our expectations for the performance of our buy-and-hold portfolios.
Since that historic market feat of 2013, options sellers have once again thrived. Just look no further than the year-to-date performance of the two credit spread portfolios in my Options Advantage service. We’ve made over 100% in our vertical spread portfolio and over 160% in our weekly portfolio.
I recently received an email from an Options Advantage subscriber who has had similar success this year:
“I have been trading with you since the beginning of Dec. 2014, I am very pleased.
I have used others over the past 3 years with mixed results but I have done a total of 29 trades with you and only lost on 2 trades, that is pretty amazing. One of them was the AAPL trade in Jan/Feb but we won’t talk about that. I understand that is going to happen now and then.
I feel very comfortable trading with you and your trading emails are very detailed and answer all the questions. …
I have been using another who trade weeklies, with mixed results, so I am going to pretty much just stick with you and forget about using anybody else.
I just wish we had more trades, especially on the weeklies. I know you say it’s a marathon and not a sprint. Sometimes I have had a frustrating time with that … but I’m sure that is why I have only lost on 2 trades out of 29.
Keep up the good work. … And if you want to trade more I am there for ya!”
I’ve been receiving lots of similar emails recently. But, I’m not going to take all the credit. Proper credit must go to the return of volatility back to normal levels and the mechanical system I teach to my subscribers.
On Thursday, June 25, I will be giving another monthly presentation on how I trade options. I will be discussing the same strategies and mechanical system I have used over the last 17 years with great success. These are the same strategies that have allowed me to outperform the market in 2015.
If you would like to learn how to implement these strategies in your portfolio, please make sure you sign up for the presentation. If you can’t make it, no worries. We will send you an email of the discussion shortly afterward. Click here to join the event!
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