I have had a lot of people ask me they can’t seem to find any opportunities. They want to know if they are looking in the right place, are their calculations correct, what is it that they are missing in their research that isn’t giving them any opportunities? The only cheap stuff they are finding are the garbage stocks that we don’t want to own. What I tell them right now is to be patient and do not get frustrated. Here is why: if you watched my recent video about the Buffet Indicator and the S&P 500 historical PE ratio, you will see that today’s market is at an unprecedented overvalued level. The Buffet Indicator average level is between 75-90. Its significantly overvalued at 115. Today it is over 121 as you can see in this chart:
The good news is that it has declined in the last 2 weeks from 129, but as of today, Wednesday, January 4, 2017, the market is still significantly overvalued based on the Buffet Indicator.
If we take a look at the historical PE on the S&P, its average is about 15.5 and today it is at 25.5 as you can see here:
Still way overvalued. The only way this market will return back to a normal level is if companies start reporting higher earnings, or if we have a correction. Until either of those scenarios play out, we are stuck with the market condition that we have. So, if the entire market is overvalued, and we are looking for the best companies in this market at undervalued prices, we are essentially looking for a needle in a haystack. When the market is undervalued, bargains can be found everywhere, so our job is much easier. Now it’s harder and we have to look further, develop more patience, and also use another tool from our toolbox, and that is the short put strategy. It makes no sense breaking the main rule of our Value Investment strategy and that is buying stocks at a discount. If there are no discounts, don’t buy unless you want to lose money. We can create a discount if we sell puts on great companies. We may need to sell long term puts, and that is ok, because they pay a higher premium, and we can always close out the trade sooner if it works in our favor, or roll out to a longer term if it’s a losing trade (see my article on Rolling strategy).
Take a look at Manpower (MAN). It fully recovered from the Brexit drop and its back to $88/share. Let’s say you want to own that stock but not at $88. We could sell a put with a potential purchase price of $70. Currently the longest term Put for MAN expires in June, 2017. The premium collected is $1.90. In a non-IRA account, you only have to have 30% of the potential purchase price of $70 available. That’s if you have 100k or more. Under 100k, you have to have 50% available. Some online brokers will allow you 20%. I use TD and my risk based margin is 30%. In an IRA this doesn’t work as well because you have to have 100% of the potential purchase price of the stock available and that has to be in cash.
Assume we do this in our Non-IRA. The potential purchase price is $70 because that is the strike price we chose and we are obligating ourselves to buy this stock at $70 if it falls to this price by the expiration date that we also chose. I have to have 30% available based on my risk based margin which equals $21/share. I am collecting $1.90/share on the premium I collected. Here is how this Put trade worked out: $1.90/$21 = 9.04% for 6 months until expiration (18% Annualized Return). Not bad compared to what money market rates are paying. Keep in mind, this trade is profitable in 3 directions. If the stock continues up, we are not forced to buy the shares at $70, so we keep the $1.90 in premium. If the stock goes nowhere and stays at $88, we are not forced to buy. We keep the premium. If the stock goes down, buy not past $70, we don’t have to buy and we keep our $1.90 in premium. If the stock goes below $70, that is what we really want to happen because now we get to buy the stock we wanted to buy in the first place, but now we get to buy it at a discount. Win, Win, Win, and WIN.
Let me give you one more example: CMI was another huge winner we had this year. I bought it for my clients and myself at $85, I had a $118 target price and sold it at $127. That’s a bummer for me because now it’s at $146. It was very overvalued when I sold it but it kept on going up. It’s safe to say we shouldn’t buy it at today’s price, but it is a phenomenal company. If we want to buy it at a lower price, say, $100, we could sit and wait or we could sell a put. They have 2 long term puts available for this company. We could sell the January 2018 or Jan 2019 Puts. I will use the Jan 2018 for this example and we will sell the $100 strike price. That will give us $3.80 in premium. Using our risk based margin, we need 30% of the potential $100 purchase price which is $30. Another good looking trade: $3.80/$30 = 12.6% annually. We want to buy the stock, but if we don’t, we still make an incredible rate of return for a strategy that lets us make money in 3 directions. And the stock has to fall over 30% before we have to buy it.
So, in an overvalued market, be patient and wait for the stocks to come back down to earth. Don’t rush in to buy something just for the sake of it. Be smart with your money and use the Put options strategy to give us the discount we are looking for and make money while we wait for that discount!