The title of this song from one of my favorite bands, Queen, came to mind today as I thought about today's price action. This bull market, that by all measures should not be continuing higher, did just that again today. SPX tacked on another six points to close at $2190, while RUT spurted higher by $12 to close at $1242. And the NASDAQ Composite did not want to be outdone, gapping open this morning and gaining $29 to close at another all-time high at $5262. All-time highs are becoming passe.
Many valuation measures, such as the price to earnings ratio and the average dividend yield of the S&P 500, suggest a pricey market. We are nearing the end of the second quarter earnings announcement cycle, and earnings have declined once again on a year over year basis. When you think about it, the only way the P/E for the S&P 500 may continue to rise is that share prices are rising faster than earnings are declining. At its most fundamental level, stocks are priced on the value of the discounted cash flow of the projected earnings. Yet prices continue higher as earnings decline.
Don't misunderstand. I am not trying to say the market has it all wrong. The ultimate arbiter is the market price. But that brings me back to the title, Another One Bites the Dust. In this context, another bear covers his shorts. Where does it end? No one knows. But it is clear that we are increasingly on thin ice.
So what should we be doing in this market? I don't presume to have all the answers, but my trading boils down to a few bullet points:
- I am continuing to play bullish stocks as they trade higher. But I am using diagonal call spreads to give myself some safety margin on the downside, just in case the market pulls back one of these days.
- I am closing profitable trades early to lock in gains. If I can bank 70-75% of the potential gains on a trade, I take it.
- As I position my non-directional trades, I am allowing for more safety margin on the up side. I am not betting against the bull.
- I am as nervous as a long tailed cat in a room full of rocking chairs.
Make money while you can, but be careful out there.