Friday, November 24th, 2017

When Earnings Fall Stock Prices Are Next

 

The best argument for why the stock market rally continues in the face of overpriced stocks is that earnings have been strong. But when the market is leveraged to the hilt and earnings disappoint what happens? The fact is that when earnings fall stock prices are next. Reuters writes that stocks fell when bank earnings were weak.

U.S. stocks fell on Thursday morning, dragged down by media companies, while results from JPMorgan and Citigroup failed to fuel the optimism that has driven indexes to record highs.

“After a long stretch of consecutive highs in the market, with earnings, even if they are slightly disappointing, or an even an aspect of earnings like bond trading at JPM, is more an excuse to selloff,” said Scott Clemons, chief investment strategist for Brown Brothers Harriman in New York.

The point is that there are big investors who have been hanging on for the last bit of gain before exiting the market. These folks are looking for an excuse to get out. But is there an alternative to selling stocks when the market might still have a ways to go? Buying puts on stocks that you own allows you to hold the stock in case of an upside move and protect yourself against a market correction or crash. A put contract in options trading gives the buyer the right to sell his stock at a set price even if the market falls. The buyer pays a premium for this sort of insurance which lasts for the duration of the options contract. When the cost of a put option is not too large this is a good route to go to protect your gains in a rising stock. When the market has decided that your stock is too risky the price of the put option will be prohibitive. That is when it will be time for you to sell before the crash.

Like the 1987 Crash

As earnings falter how will this market rally end? CNBC writes that the 1987 bust is a guide. They say that the market may still rise a bit which they refer to as a melt up.

“A melt-up to a certain extent kind of creates its own demise. To the extent that this market continues to move higher, maybe starts to move higher at a faster pace, now that would indicate to me that a lot of investors are coming in a little late into this bull market, and doing it with ETFs,” Yardeni said Tuesday on CNBC’s “Futures Now.” “As in 1987, they could create a sort of portfolio insurance effect where suddenly something happens.”

He’s referring to the crash on Oct. 19, 1987, otherwise known as Black Monday. It’s the day the Dow plummeted by 23 percent after early computers on Wall Street spotted market weakness and tried to protect financial institutions by selling. But they weren’t sophisticated enough to stop.

That time it took the market 15 months to recover its losses. The same advice regarding buying puts applies here as well.

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