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Two weeks ago, a friend and I were enjoying a couple mezcal margaritas after a nice dinner when a 21-year-old bar back overheard our market-centric conversation and excitedly told us that he had just bought his first shares of stock after hearing how strong the market was from a friend.
Nothing against the 21-year-old bar backs of the world, but after five minutes of chatting, I realized he was mostly clueless as to how stocks derive their value. Worse still was his extraordinary confidence.
But his behavior is quite common. Many investors hear a tip, buy a stock and hope for the best. In fact, one of the most common anecdotes I've heard on Wall Street is how market neophytes can predict the end of a trend.
Said another way, when the average waiter, fast food employee or bar back tells you how great the market is doing, it's probably time to get out.
The logic is that hedge funds and Wall Street insiders are often the first to get in, driving much of a rally, then the wealthiest investors with the best advisors hop on board, followed by savvy traders and self-directed investors, with the common citizen last to join the party after news of the rally finally reaches the masses.
By the time all of this happens, valuations are typically astronomical and the smart money begins selling to capture the massive profits they already have on the table.
So I began to dig deeper to confirm my bar back indicator and look for the best way to profit from this trend. What I found led me to a 6,759% annualized profit. What's more, there's likely to be plenty of other opportunities in the near future to book outsized gains as the last few bulls pile in.
Here's what my research turned up…
Everyone Already 'All In'
Back in early 2015, we had no idea just how fragile China was, and growth in S&P earnings was still positive. As the market soared, so did market sentiment, as measured by the National Association of Active Investment Managers.
But following those "happy days" of investor sentiment in April 2015, stocks saw three minor corrections -- in May, June and July -- before completely unraveling in August and again in January.
Market sentiment is now back where it was in early 2015, which is pretty darn bullish considering that the basic fundamental situation is much worse.
The S&P 500's trailing price-to-earnings (P/E) ratio is 3.7% higher than it was a year ago, which means stocks are even more expensive. And earnings growth, which was slightly positive in Q1 2015, is on track to decline for the fourth consecutive quarter -- a feat not seen since the Great Recession.
And yet, the market seems irrationally calm.
This surprising investor complacency is also reflected in the Volatility S&P 500 (VIX).
The VIX tells us how much "fear" or volatility premium is factored into the price of options. When investors believe stocks will go up in an orderly fashion, VIX is low; when investors are scared and see large, usually bearish moves on the horizon, VIX surges higher.
Currently, we're seeing the VIX trading back below its long-term average (red line) and near year-ago levels.
Very low VIX readings like we are seeing now are generally a good sign that all the bulls are already in the market.
Unlike my giddy bar back friend and a good number of average investors, the smart money is NOT buying here. There's a saying on Wall Street: "When the VIX is low, it's time to go."
When the market is as bullish as it can be, it's an ideal time to start taking profits. If every last bull is already in the market, it means there isn't anyone left to step in and stop prices from falling.
The (Fundamental) Canary in the Coal Mine
For the first time in years, analysts are predicting the tech sector will see negative quarterly earnings growth. Just a few quarters ago, earnings were growing at a rate of 16%-plus.
We've already seen major earnings hiccups from some of the biggest and best tech companies this quarter, including Alphabet (NASDAQ: GOOGL) and Microsoft (NASDAQ: MSFT).
As a market leader, tech is basically our canary in the coal mine. If tech is turning sharply negative, we should take it as a warning that it's time to head for the exits.
With overly bullish investor sentiment, an extremely low VIX, negative earnings and weakness in tech, I concluded the S&P 500 was ripe for a pullback and set about finding the perfect trade.
How a 1% Market Decline Turned Into Massive Gains
If you're familiar with me, you know that I use options to leverage moves in the market and individual stocks. That's because trading options is the best way to increase leverage and percentage returns while preserving capital and reducing risk.
On Friday, April 29, I told readers of my Profit Amplifier service to buy a put option on SPDR S&P 500 ETF (NYSE: SPY) with a strike price of $212 that expired in June.
Now, when I recommend an option, I never tell readers to buy "at the market." Rather, I set a limit price that is the highest price I am willing to pay for that option. In this case, the limit was $6.75 ($675 per contract).
This is important because overpaying for an option can severely limit your profit potential. Not only that, but option prices typically move much faster than stock prices. This is why with every trade I recommend, I also tell traders upon entry to place a limit order to sell the option at my profit target. Automating your exit up front eliminates the need to be glued to your computer screen all day and protects your profit if the market suddenly turns against you.
Getting back to the SPY trade, I sent my recommendation on Friday, April 29. On Monday, the put options traded below my "buy under" price of $6.75 and our orders were filled. The following day, SPY fell 1%, sending the puts soaring and our position was automatically closed, giving us an 18.5% gain in just one day, or 6,759% annualized.
That kind of gain is nearly impossible with stocks, even if you fancy yourself a day trader. And while not all the returns are this extraordinary, my average Profit Amplifier trade has returned a 123% annualized gain with an average holding period of 27 days.
If you're interested in learning more about this service -- and how it can help protect your portfolio from the next market sell-off -- follow this link.
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