By virtually every metric, the broad market is overvalued. Stock prices have historically correlated to earnings over the long-term. Of course, the market can be overvalued or undervalued compared to the long-term mean for periods of time.
However, when we look at earnings expectations for the S&P 500 and then look at the price-earnings ratio of the market, we see the P/E is about 20% higher than earnings indicate.
That means it may be time to buy some puts. Puts are options bets. You buy puts if you think a stock or an index is going to go down.
Some investors use puts to just make a bet on the direction of the market to make money. Others use puts to hedge their long positions. In fact, some will buy puts on indices to hedge long positions in specific stocks.
Puts for a Possible Correction: SPDR S&P 500 ETF (SPY)
The easiest approach is to buy puts on the actual S&P 500 via the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).
Now I am not a fan of buying puts just for the hedge, but the purpose of today’s article is for those investors who are nervous about the market being overextended. As I said, I do believe the market is overvalued and is ripe for a correction of 20% or more.
So in reference to the SPY and what to do, it may make sense to protect against some downside, but not all of it, so as to be careful not to overpay. With the SPY trading at $225.81, you want to protect against something greater than a 10% correction or so. So buying the Jan. 27 $200 puts for 4 cents is a cheap move.
You can even go further out and buy the March 17 $200 puts for 67 cents. Again, you’re paying a mere 0.3% for protection.
Puts for a Possible Correction: iShares Russell 2000 (IWM)
It isn’t just protection against the S&P 500 you may desire. If the market were to correct in a very big way, other indices would likely plummet along with it. It may be worth looking at a broad index like the Russell 2000.
This index, represented by the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), is basically regarded as the small-cap stock index. It’s usually the benchmark for any mutual fund that calls itself a small-cap fund.
The IWM consists of the bottom 2000 stocks in the Russell 3000 index, or about 8% of that index in terms of market cap.
It’s trading at $136.14 as I write. In the near-term, you could buy the Jan. 27 $123 puts for a mere 13 cents, which is chump change. While the March 17 $123 puts go for $1.19. You could even go out as far as June 16, and pay $3.10, although it does get expensive there.
Puts for a Possible Correction: PowerShares QQQ Trust (QQQ)
Another way to go is to buy puts on the PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ), which represents the Nasdaq 100. With the QQQ, the top ten holdings make up 50% of the index, and it represents the 100 largest market capitalization stocks in the Nasdaq.
In other words, these are the big-name tech stocks everybody has heard of. Some of these are actually priced respectably, but would likely be the first to sell off and the first to recover. They may or may not sell off the most, but certainly could get hammered in a very large and broad correction.
The QQQ is trading at $122 as I write.
The Jan. 27 $108 puts can be bought for next to nothing — 2 cents per contract. However, the March 17 $108 puts can be bought for 48 cents. If it’s slightly higher, it’s because the volatility is higher. It still may make some sense, though, if you want to protect long positions in any of the big name stocks.
Lawrence Meyers is the CEO of PDL Capital, and manager of the forthcoming Liberty Portfolio stock newsletter. As of this writing, has no position in any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
