Stocks went on a tear in June. Does that heighten future risk for investors?

For the answer to that question and others, I turned this week to my colleague A. Hestla, chief investment strategist of the trading services Income Trader, Profit Amplifier and Maximum Income. Hestla specializes in generating income using options strategies that minimize risk.

Hestla served with the U.S. Army in Operation Iraqi Freedom. While deployed overseas with military intelligence, Hesta learned the importance of interpreting data to forecast what is likely to happen in the future.

It’s a skill that helps Hestla find hidden investment gems that go on to score market-crushing gains, in up or down markets and in economic expansions or recessions. As an increasing number of analysts call for an economic downturn within the next 12 months, this sort of expertise is more vital than ever.

Let’s tap Hestla’s latest thoughts about the world stage and financial markets.

JP: Stocks are on track for their best first half in 22 years, with the S&P 500 hitting record highs. We’re now enjoying the longest bull market ever. Are stocks as a whole overvalued? If so, what should investors do to protect their portfolios from a correction?

AH: Stocks are absolutely overvalued. The price-to-earnings (P/E) ratio on the S&P 500 is about 26.

By definition, that’s overvalued. The long-term average is around 16 so you could argue that stocks are about 60% overvalued. But it doesn’t matter.

The P/E ratio was above 25 from late 2016 to early 2018 when the S&P 500 index gained 38%.

I think the best to way to look at this is to acknowledge that stocks are overvalued but also to understand stocks can get more overvalued. Eventually, valuation will matter. But for now, the most important factor seems to be sentiment.

Traders are bullish and we know they are bullish because we see buyers coming in on dips. This should continue.

There is still at least $3 trillion in money market funds and that money is easy to move into stocks. In fact, much of it is simply parked there waiting for an opportunity to move into stocks.

So, every time we see a dip (a 5-10% decline), investors move cash from money markets to stocks.

With the Federal Reserve likely to cut interest rates, this process could accelerate. Many traders are calling this a TINA market, There Is No Alternative to stocks. Until rates rise significantly, this will remain true and that means there could be significant upside in the current market.

Stock prices won’t go straight up but the trend is up and unless the news changes sentiment suddenly, the trend should remain up. Bad news associated with Iran, tariffs, Brexit, the euro or dozens of other potential problems could change sentiment suddenly.

This means it is important to follow surveys on consumer sentiment, investor sentiment and other data that offers insights into what everyone is expecting. Expectations are driving stocks for now and higher expectations are the only significant reason to expect additional gains.

Investors have been cheered by the Federal Reserve’s dovishness on interest rates. Do you expect another rate cut this year?

The Federal Reserve has been forced to follow the market since 2013 when Bernanke misspoke and sparked the selloff that became known as the “Taper Tantrum.”

Market prices of Fed funds futures show a 100% probability of a rate cut this year and the Fed cannot ignore that. If they fail to cut, the stock market will crash, and a recession will follow as consumer sentiment declines.

For now, the Fed is forced to follow the market and they will cut at least once this year.

Are investors overthinking Fed policy? The financial press seems to obsess over every vague utterance from Fed Chair Jerome Powell.

It’s not possible to overthink Fed policy. Monetary policy explains the most important trends in the stock market.

Sticking with recent history, the Fed gets credit for being aggressive in 2009 and heading off a repeat of the Great Depression. They also get blamed for being too accommodative and allowing assets like stocks and real estate to go too high over the past 10 years.

The Fed has always been important to the stock market. Before the Fed existed, money supply explained many important market trends and crashes.

Here’s a simple example, before the Federal Reserve was created, panics were fairly common in the fall. Without a central bank, money supply moved across the country in response to demand.

In the fall, demand was usually the greatest in the western states where farmers were bringing in crops. Cash was needed to pay for the crops and the cash was often used to pay off loans to banks which then shipped the cash back east.

With physical cash in short supply in eastern cities, including New York where the stock exchange was located, panics were relatively common in the fall. There were other factors and that explains why there were panics in some years and not in others but there was a logical explanation for why panics and stock market selloffs occurred in the fall more often than in the spring.

The Fed solved that problem, but regional demand for money was still causing problems as late as the 1930s.

Now, we have a simple way to track monetary policy and, in some ways, it’s almost like it was in the 1970s and early 1980s.

I spend a lot of time talking to old traders and some describe waiting for the weekly money supply report. In the 1970s, the Fed was more secretive, and this report was the only insight into monetary policy. There weren’t even statements after meetings like we have today. That report would often lead to big moves on Fridays.

Money supply data is still released after the close every Thursday, but it’s not widely followed anymore.

The media can’t spend time on things as boring as the weekly “Money Stock and Debt Measures – H.6 Release” so this doesn’t get noticed.

Getting back to your question, it’s true, investors don’t need to obsess over vague utterances from Powell and other members of the FOMC. But they should focus on the H.6 release and the H.4 release detailing the Fed’s balance sheet. This is where we have the data about the money that drives stock prices.

During this late stage of the economic cycle, what are the most appealing sectors now and why?

I know many analysts are saying that we are in the late stages of the economic cycle. That assumes the cycle will die of old age. Unfortunately, we have no way of knowing where we are in the cycle. The cycle is old; right now we’re enjoying the second-longest expansion on record. It’s on the verge of becoming the longest. But it could keep going and it will keep going until it reverses.

The data I look at don’t show we are late stage. The best performing sectors in the stock market over the past six months are aggressive sectors. Normally we would look for defensive sectors to perform well in the late stages. Take a look at these two charts that I put together.

Defensive sectors are among the worst performers. So the numbers say there is more room for upside in this stock market.

As to which sectors are appealing, I like the ones that are delivering the best performance. That’s software, hardware and semiconductor makers and retailers.

This data changes all the time so when following sectors, it is important to look at performance at least once a month and ideally weekly. I have the perspective of a trader and believe it’s important to buy stocks that go up and sell or buy puts on stocks that go down.

Following the data can help us avoid catastrophic losses. I think investors with emotional views about the long term are the ones who can suffer devastating losses because they ignore trends in the data and make decisions on what they hope will happen.

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