A Quick Trade On A Longtime Winner

Amber Hestla's picture

Wednesday, February 6, 2019 - 12:00am

by Amber Hestla

I saw an interesting chart recently that I believe summarizes the current state of the stock market. 

Essentially, it shows that U.S. stocks are extremely overvalued compared to the rest of the world. 

Why does this matter? And, more importantly, how can we profit? Now, those are the key questions...

But first, let's use what we know as investors to unpack the information. 

The chart below shows the cyclically adjusted price-to-earnings (CAPE) ratio for both U.S. and global stocks. It was developed by Nobel Prize-winning economist Dr. Robert Schiller. 


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CAPE chart

Source: Global Financial Data via MebFaber.com 

Cyclical, in this case, means the indicator measures over 10 years, the amount of time Schiller believes covers an economic cycle.

Ben Graham, the father of fundamental analysis (and Warren Buffett's business school professor), explained the importance of accounting for the economic cycle when calculating earnings. Graham suggested averaging earnings over eight years to account for the elevated earnings of a company at the top of an economic cycle and the low earnings at the bottom of a recession. 

Averaging the earnings makes the P/E ratio smoother and more accurate, according to Graham and Schiller. 

Schiller adjusts the earnings for inflation. That makes sense as many companies reported strong earnings when inflation was high in the early 1980s. Many companies were heading for trouble as earnings grew because costs were rising also, and earnings artificially inflated by inflation masked that problem. 

Schiller argues CAPE is mean reverting in the long run, and high readings are followed by low readings while low readings are followed by high readings. This cycle can be seen in the chart at the top of this issue. 

For the United States, CAPE sits at about 29, well above the average value of 22 seen since 1980. For global stock markets, CAPE is 16, which is well below the average of 22. 

It's interesting that global stocks and U.S. stocks have the same long-term average CAPE. It's also interesting that the two lines in the chart move above and below each other. Given the current status, we should expect the CAPE ratio to converge. 

That could happen if global stocks become overvalued or if U.S. stocks become undervalued. Either way, this data is telling us that, in the long run, we should expect stocks of companies outside the United States to outperform.

A Repeat Winner
This is a long-term expectation, and it's something I considered when picking my most recent trade recommendation of PVH Corp. (NYSE: PVH) in my premium Income Trader service. 

PVH is a retail licensor that focuses on clothes and fashion. It generates about half of its revenue outside the United States. 

You've definitely seen PVH's products if you've shopped for clothing... The company sells clothing and accessories under a variety of brand names including Calvin Klein, Tommy Hilfiger, Van Heusen, IZOD, Speedo, Geoffrey Beene, Kenneth Cole, Michael Kors and Chaps brands. 

These products are department mainstays but are also available at outlet stores and discounters. They are brands associated with value more than style and command a surprisingly large share of the market. More than 50% of men's ties sold are made by PVH's Heritage Brands, as are more than 40% of the dress shirts sold in department and chain stores. 

We've successfully traded PVH multiple times in the past two years over at Income Trader. And now, we're going back to the well...

A Rare Value
Last year, PVH's stock suffered a significant decline, but it now offers tremendous value with a P/E ratio of less than 11 based on expected earnings. It also just gave a "buy" signal, according to my Income Trader Volatility (ITV) indicator, which means now is the ideal time to sell a put option on the stock.

PVH chart

While I can't reveal the exact details of this trade out of fairness to my Income Trader readers, I can tell you a little about what we're doing... 

Since we're in the business of selling put options, we're essentially betting that PVH will not fall below a certain price by a certain date. 

When we make the trade, we earn a premium upfront -- which is why I like to call this "Instant Income." In this case, we'll pocket about 2.5% on our capital in 17 days. If everything goes according to plan, then we'll pocket the premium we earned and simply walk away from the trade. What's more, we can repeat a similar trade again and again... (Remember, we've made successful trades on PVH several times.)

In the event we're wrong, and PVH falls below our specified price, we'll be obligated to purchase the stock. In this case, that isn't such a bad thing, since we'll be buying a solid stock with a favorable long-term outlook at a discount.

How To Make Trades Like This
If this sounds enticing to you, that's because it should. It's the closest thing you'll get to a win-win when it comes to investing.

Since starting Income Trader a few years ago, my subscribers and I have made hundreds of trades like this... and we've come out ahead more than 90% of the time. 

It just goes to show that options don't have to be risky or complicated. If you take a few simple steps to learn how they work, they can be a powerful tool -- far more powerful than relying on dividends alone. If you'd like to learn more, simply visit this page right now.

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.