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When I first noticed a bearish triangle formation on the chart of the S&P 500 (CBOE: SPX), I had a strong sense that a sell-off was coming. This is one of the more powerful bearish signals, and sure enough, the dramatic drop on Oct. 11 and lack of an immediate bounce demonstrated underlying weakness.
With market fundamentals still shaky, this could very well be the start of a larger correction.
An Earnings Downturn to Rival the Great Recession
Even though earnings growth is expected to turn positive in the fourth quarter, it's much too soon to break out the champagne. Analysts expect Q3 to be the sixth straight quarter of declining earnings growth, tying the Great Recession for the longest earnings recession on record, according to data compiled by Bloomberg.
Goldman Sachs (NYSE: GS) Chief U.S. Equity Strategist David Kostin wrote in a note to clients that they should expect a below-average number of companies to report positive earnings surprises.
What's more, he said: "We see a weak third-quarter reporting season coupled with negative fourth-quarter EPS revisions pushing stocks 2 percent lower to our year-end target of 2,100."
Earnings growth has been negative despite tactics like share buybacks, mergers and aggressive cost-cutting, while valuations remain disjointed from reality. The forward price-to-earnings (P/E) ratio of the S&P 500 is near record levels at 18.4, higher than the peak of the Great Recession.
But unlike recession peaks that statistically precede growth and therefore justify high valuations, we have been in an economic expansion for 88 months. Statistically speaking, the odds of a recession are much higher than the odds of further expansion.
The Dollar, the Fed, the Donald! Oh My!
In addition to falling earnings and stocks trading at nosebleed levels, the market has to contend with a strong U.S. dollar continuing to weigh on international sales.
Roughly half of S&P 500 company revenues come from overseas, and the greenback is strengthening against most of the world's currencies as the Federal Reserve moves toward another interest rate increase.
Then there's the upcoming presidential election, which is almost certain to have an effect on the market... although which direction stocks will go is anyone's guess.
Several prominent names in business -- including Kellogg (NYSE: K) CEO and former Secretary of Commerce Carlos Gutierrez -- recently released a collective letter outlining their concerns about a Donald Trump presidency. The letter questions Trump's business acumen, which the authors view as bad for the U.S. economy. Dallas Mavericks owner and billionaire Mark Cuban even predicted a market crash if Trump is elected.
On the other hand, Trump could shake up the markets in a good way with his promises to even out our trade deficit, reinvigorate American companies and cut taxes. Yet, he warned investors to steer clear of stocks back in August, adding another layer of confusion to the market puzzle.
Others argue a win for Hillary Clinton would be a good thing for markets, expecting her to carry on agendas similar to the ones put forth by her husband and President Obama. But it's also possible that Clinton will get tougher with regulations, and her tax policies could hinder the growth of some businesses, as well as consumer spending.
This leaves traders who would rather not engage in risky political speculation with few options. They could certainly join the buy-and-hold crowd by sitting anxiously on the sidelines for the next three weeks. Or they could find a way to dodge much of the uncertainty and still set themselves up to book profits by Election Day.
I don't know about you, but I'd take the latter any day of the week.
How I Plan to Profit Before Election Day
Given all the uncertainty we currently face, it's highly unlikely investors will rush to commit new money to stocks or that the S&P 500 will eclipse its all-time high of 2,194 before the election. It's even more unlikely the index will break above 2,200 -- a big, round-number resistance level.
So, I'm going to employ a simple options spread strategy known as a bear put spread.
It involves simultaneously buying one put option and selling another with the same expiration date but a lower strike price.
Here's what you need to know about bear put spreads:
1. You will always trade the same number of long and short puts -- if you buy one, you sell one.
2. The option premium from the put sold (short put) decreases the cost of buying the long put.
3. The most the trade can be worth is the difference in the strikes.
4. The most you can lose is what you pay to initiate the trade.
5. The goal is for the stock or index to stay below the short put strike. As long as it is below that level at expiration, the maximum profit is achieved.
I recently recommended a bear put spread to subscribers of my Pro Trader service using S&P 500 (CBOE: SPX) options. Specifically, it was the SPX Nov 7 2205/2200 Bear Put Spread.
This spread uses two separate put trades:
Buy (to open) SPX Nov 7 2205 Puts
Sell (to open) SPX Nov 7 2200 Puts
For this trade to achieve its maximum profit, all we need is for the S&P 500 to be below 2,200 on Nov. 7, the day before everyone hits the polls. That means the index could fall, stay flat or even rise another 2.8% between now and then and we'll still come out winners.
While it wouldn't be fair to my Pro Trader readers to share any more specifics here, when I issue spread trade recommendations to them, I also provide detailed entry and exit instructions with specific buy under prices and sell targets.
This way they know up front exactly how much is at risk and what they stand to make. For the trade above, for instance, we're aiming to book a 15% profit in the next three weeks. That's a pretty attractive return, especially when you consider that many investors will likely be biding their time till we know the outcome of the election.
There's still time to get into this trade if you're interested in joining Pro Trader. You can learn more about the service here.
If you're not convinced about the power of spreads, consider this: Of my first 23 trades I put together in preparation for Pro Trader, 19 of them were winners. The average return was 11% in 20 days, which works out to a more than 200% annualized gain.
If potentially tripling your wealth in the next year is appealing to you, I strongly suggest you at least check out this presentation I've put together on how to implement basic spreads in your own portfolio.
As I'm sure you are all aware, stock prices have been unusually volatile lately...