Volatility has increased this year. And now that we have some data on earnings, so we can gauge the probable direction of future volatility.
Earnings were generally strong in the most recent quarter, but they were also largely distorted by the new tax rules.
You see, companies are required to account for changes as soon as they can understand the impact those changes will have on their financials. This is one of the principles contained in the accounting standards known as GAAP, or generally accepted accounting principles.
For the most recent quarter, FactSet Research reported the difference between the two types of results for companies in the Dow Jones Industrial Average was 110%. The difference was just 10.1% in the previous quarter and averaged 12.4% in 2016.
While this large difference makes it more challenging for analysts to forecast earnings, the updated earnings estimates for 2018 have started coming in coming in. (Earnings for the index are weighted in the same way share prices are weighted to calculate the price.)
Where The Market Is Going From Here
To develop our own year-end price target for the index, all we need to do is pick an earnings estimate for the S&P 500 and then assign a price-to-earnings (P/E) ratio.
So, analyst earnings estimates for the S&P 500 are ranging from $150 to $160 a share. Personally, I prefer to use more conservative numbers in my analysis (being happily surprised is always better than the alternative), so let’s use an estimate of $152.50 — near the low end of the range.
Now we have to determine an accurate P/E ratio to apply. I believe it’s best to use the average P/E ratio since 1958 when developing price targets. The average P/E for this period is 19; after subbing in that figure to our analysis, we get a target of about 2,900 for the S&P 500.
A bout of irrational exuberance could push the index towards 4,000, a level that would push the P/E ratio just one standard deviation above average. Overall, I think somewhere between 3,000 and 4,000 is the right target for the index.
That might sound like a wide range… because it is. But our goal here isn’t to determine the exact year-end value of the index with pinpoint accuracy. We’re simply trying to develop a trading strategy. Based on this analysis, my conclusion is that that:
1. As I write this, the S&P is trading around 2,700. That means there is significant upside potential in stocks.
2. High volatility is also likely.
Based on this, I want to focus on trades that have significant income potential, but I want to do all I can to also reduce risk.
In keeping with that philosophy, this week’s recommendation for my Income Trader subscribers was in AbbVie (NYSE: ABBV).
Revisiting This Reliable Trade Target
I’ve written about AbbVie a few times before. (So far, we’ve made trades on ABBV three times, and all three trades were winners.) It is one of the world’s largest drug makers (the seventh largest by market cap), known to many for its best-selling drug, Humira, a biologic therapy for autoimmune diseases including rheumatoid arthritis, Crohn’s disease and other inflammatory conditions. This is the best-selling drug in the world, with sales of more than $15 billion a year.
Other blockbusters include the blood cancer drug Imbruvica, which is now the first-line treatment for many variations of the disease. Another treatment for leukemia, Venclexta, is expected to bring in more than $1.5 billion by the end of the decade.
At the end of January, the company announced its Q4 and full-year results, beating estimates for both earnings and sales in both periods. Management also increased earnings expectations for 2018 based on the expectation that key drugs would continue to sell well. Specifically, the company’s most important drug, Humira, is exceeding expectations despite new competition.
Humira produced more than $18 billion in sales last year in the rheumatoid arthritis, Crohn’s disease and eczema markets. AbbVie also has a new, late-stage drug candidate positioned for that market, called upadacitinib.
Last year, AbbVie reported results from a trial of the drug with patients that had not responded to previous treatment. The company reported that patients taking relatively low doses of the experimental drug reported clinical remission at a rate three to four times higher than those given a placebo.
AbbVie expects to submit a rheumatoid arthritis application package for upadacitinib in the second half of the year. News from ongoing trials of this drug as a treatment for Crohn’s disease and eczema could be announced later this year. AbbVie tells analysts they believe the drug could add up to $6.5 billion in annual sales by 2025.
The company is also working on bringing a new psoriasis treatment to market that could compete with Johnson & Johnson’s (NYSE: JNJ) $4 billion drug, Stelara. The company reported that, in two trials, 58% and 60% of patients treated with AbbVie’s drug achieved clear skin, versus just 21% and 30% of patients treated with Stelara.
AbbVie plans to submit the drug for approval in the first half this year and believes it could add $5 billion worth of sales by 2022.
These developments, as well as other drugs, could boost ABBV’s value in the long term. But, in the short term, I expect the stock to settle into a trading range and that sets up a high-income trading opportunity.
How I’m Trading This Stock — Without Buying A Single Share
If you’re interested in catching some of the potential upside, you can always buy shares of ABBV and wait for the new drugs to have some impact on share price.
But I found a better trade… I plan on trading Abbvie a fourth time — and guarantee that I will collect 2.8% in income in just 15 days. That’s a more-than-comfortable 67.6% annualized. And all without buying a single share of the stock. This trade uses a high-income, short-term put option on ABBV.
Now, I understand not everyone is comfortable selling options, but you shouldn’t let that keep you from taking advantage of this tool. The truth is, options can be as risky or conservative as you want them to be. It all depends on the strategy you’re using.
— The Option Specialist