Why I Think The Rally Is Nearing A “Top”
Major stock market averages continue reaching new highs. That’s usually something we see either when earnings are rising or the stock market is topping. It’s more than likely we are seeing the latter event unfold.
Below is a chart of earnings estimates for the stocks in the S&P 500. The blue line shows 2020 and the orange line shows the current year.
For perspective, the next chart shows the price-to-earnings (P/E) ratio for the S&P 500 based on estimates.
Based on trailing earnings, the index has a P/E ratio of 32. Based on expected earnings, the ratio is a more reasonable 23, but it is still a premium to the long-term average of 17.
Many will argue that interest rates are low, which justifies higher P/E ratios. Interest rates are low; in fact rates on 10-year Treasury notes are below the rate of inflation. The result is negative real rates, as shown in the chart of the 10-year Treasury inflation protected security.
Source: Federal Reserve
Negative real rates are generally caused by central banks. The Federal Reserve wants to increase inflation and does this by holding down interest rates. This means that low interest rates are engineered by the Fed rather than a natural source of information for markets to evaluate.
In other words, it’s entirely possible interest rates should be higher and would be if the Fed wasn’t intervening in the market. Investors relying on the argument that low rates justify overvalued markets seem to be ignoring this reality. If rates settle at a level where the market believes they should be — instead of an artificially low level dictated by the Fed — stocks would most likely crash.
I don’t expect to see that happen soon, but I do believe stocks are overvalued and we must remain conservative.
How I’m Trading This
That’s why I recently recommended a trade in Bank of America Corporation (NYSE: BAC).
The yield curve has been getting steeper, as the next chart shows. The yield curve is the difference between long-term rates and short-term rates. This chart shows the difference between 10-year Treasury notes and three-month Treasury bills.
Source: Federal Reserve
This is bullish for banks because it means they should be able to charge higher interest rates while lowering their cost of funding. Banks tend to lend at long-term rates and borrow at short-term rates.
Now is an ideal time to buy BAC because the company will announce earnings this week. BAC has missed expectations just once in the past five years, and that was the first quarter of 2020 when many companies missed expectations as the economy was shutting down.
This all makes BAC the perfect candidates for my Hollywood Payday strategy. If you’re not familiar with how it works, just know that it’s like an “insurance” plan, allowing you to get paid upfront and protecting you from the downside.
My subscribers and I have been using this strategy to earn payouts of hundreds (sometimes thousands) of dollars for years now. And this is the ideal market to use it, so I expect many more trades like this in the weeks to come.