Market momentum is Red. The short-term bump ended yesterday, leaving the markets flat on the day. Traders have taken a lot of profits off the board ahead of the PCE Inflation reading on Thursday and any report on Fed balance sheet tightening from this afternoon.
It could be a rough day for the markets as we speculate about a PCE Inflation reading on Thursday morning. According to economists, we anticipate a 0.9% increase in personal consumption inflation compared to May.
If the reading comes in lower than expectations, it could reset the forecasts for rate hikes by the Fed during its July meeting. Currently, the markets project an 89% probability that the central bank will increase interest rates by 75 basis points.
If PCE Inflation increases 1% month-over-month, get ready for the possibility of a 1% hike in July… and another big leg down for the markets. As we hover around a bear market for the S&P 500, many investors are wondering how they should invest in this environment. I’m going to discuss two ways to do so.
Getting Started on Stock Worth
One thing that I recommend that every investor considers before going long in any market is to consider what a stock is REALLY worth. We are currently engaged in broad price discovery and valuation compression. I want nothing to do with a stock trading at ten times revenue.
But ten times earnings? There’s a BIG difference here. Ten times revenue is expensive. Ten times earnings might be cheap in this environment, depending on the sector. But pay attention to other metrics that I’ve discussed in the past. These include Enterprise Value (the total value of capital and debt owned by the stock) divided by (Earnings Before Interest and Tax). I’m usually looking at stocks trading under a seven on this ratio.
Or consider price-to-book value. The book value is the cost of the company’s assets minus its liabilities. If the company was liquidated tomorrow, the book value represents what investors would receive. Anything trading under one should interest you.
Trading the Bear No. 1
If you’re buying a stock long-term, consider position-sizing as the first way to approach each stock. For example, let’s say you are looking at buying Beazer Homes (BZH), a U.S. homebuilder trading well below its book value. Look at these numbers…
Its price-to-earnings sits at 2.2. Its price-to-book is 0.47 – or 47 cents on the dollar. And it’s trading well under its current net asset value. So, this is cheap. But in a bear market, even cheap stocks can get cheaper.
So, you’ll want to position size in this market – especially while momentum is negative. Instead of buying 100 shares right now, you might purchase 40 shares right now. Then, if the stock pulls back to $10.00, you might buy another 40 shares. And if it falls back to $8.00, you might purchase another 40 shares.
Now – you might say that’s 120 shares in the second example. Correct. Buying 100 shares today would be a cost basis of $1,192. But the cost basis of the second version would be… $1,196 ($476.20 + $400 + $320). You have positioned yourself to own more shares, and once we have a recovery, you will be in far better shape for the long term.
If the stock climbs to $15 in three years, your original 100 shares would be worth $1,500. But the Bear market strategy would give you 120 shares worth $1,800. Position sizing is a very nice way to set yourself up for a longer-term trade.
Option Two: Using Puts and Spreads
If you don’t want to own the stock today at $1,192, you can take advantage of volatility by selling cash-secured puts or credit spreads to the downside on a strike price in the future.
When you sell a put, you give someone else the right, but not the obligation, to sell you their stock at a specific strike price on a specific expiration date. Instead of tying up $1,192 today on 100 shares of Beazer, you could sell the August 19, 2022, $10.00 put for $0.40.
It would require $1,000 in margin to sell this put, as you might have to take delivery of the stock if it falls under $10 in the months ahead. However, you will get to keep the $40 for the contract. You keep the money if the stock doesn’t fall under that price. If it does, you apply the money to the purchase, meaning your breakeven price is $9.60.
You can do a credit spread if you don’t want to tie up $1,000 in margin. In this case, you sell the $10 put for August at $0.40 and BUY the $8.00 put for $0.15. In this scenario, you only need $200 in margin to cover the spread, and you collect $0.25 – the difference between the contract you sold and the one you bought.
If the stock falls under $10, you will take possession of the stock, but you cannot lose more than the $200 in margin you put up. So that $8.00 put that you purchase can protect you. But with Beazer Homes, you may want to buy the stock. And use these puts and spreads to pick the exact strike price that you’d like to own the stock.
You can do the same sort of position sizing that I recommended in the first example but use put spreads or cash-secured puts to generate income if the stock never reaches the strike price. We’ll be back tomorrow with F&Z Score stocks, and we’ll prepare for an active July.