In case you didn't notice, emotions have been running a little high in the stock market lately as the Dow has plunged to a new bear market low. Maybe it has been the excitement in the banks or all the talk about nationalization that has gotten people all riled up. Or maybe it was the goings on in Washington that has people speaking their minds about what the new kids on the block are doing/planning. But to be sure, the situation appears to be reaching a fever pitch.
For example, we recently got a first rate rant on CNBC about the administration's housing bailout plan from Chicagoan Rick Santelli. And while Mr. Santelli isn't known for holding his tongue, he obviously struck a nerve in the White House as he received a very unusual and very public tongue lashing from Press Secretary Ron Gibbs, the likes of which we haven't seen since Nixon attacked CBS's Dan Rather.
But it wasn't just the commentators on the so-called "cable shows" that were a little emotional. (And by the way, since the new administration doesn't seem to be terribly familiar with the way Wall Street works, I wonder if Mr. Gibbs knows that the little cable TV station he referred to - aka CNBC - is seen all over the world. This isn't exactly public programming in Omaha! But, oops, I might just be ranting a little myself here.) Former Fed Chairman and Obama economic advisor Paul Volcker also got into the act of inciting emotions by stating that this was the fastest plunge in global economic activity ever. And yes, that includes the Great Depression.
So, with the stock market declining on a daily basis and in the process, revisiting levels not seen since 1997, as well as the minor revolt over what is perceived as the government bailing out anybody and everybody to make up for the money the government put into Wall Street, we thought it might be a good idea this weekend to step back from the emotion of the moment and take a look at one of the keys to the stock market - valuations.
It has been said that the stock market is itself a study of emotions in motion. The idea here is that investors will buy or sell the future revenue stream of a company based on how they feel at the time. If times are good, an investor might be more than happy to pay 30 or 40 times next year's earnings (think 1999 here) because they probably expect earnings to accelerate. However, when times are bad, stocks experience what is called "multiple contraction," which, in simple terms, means investors won't pay as much for the future earnings because the growth rate of the company's earnings may be in jeopardy.
Getting to the topic at hand, if you want to start an argument amongst financial analysts, simply start talking about market valuations as there are a myriad of ways to try to put a fair value on a company or index. But, let's give it a shot anyway as Market Valuation is one of the key drivers to stock prices over the long term.
There are basically two ways to look at valuations: Relative and Absolute. The first approach looks at stock prices in relation to competing interest-bearing investments such as bonds and T-Bills. And if we look at things such as earnings yields, dividend yields, bond yields, etc, we can argue that the S&P 500 is the most undervalued it has been at any time in the last 50 years. And as the bulls will tell you, this is a big-picture positive.
However, another way to look at valuation is what companies are paying in terms of dividends. The reason we like this approach is dividends represent cold hard cash that companies are willing to part with. Thus, it can be argued that dividend payments reflect the current level of confidence a company has about its future.
Let's contrast this approach to the more popular valuation measure based on earnings - aka the P/E ratio. In short, the problem with the P/E ratio is the "E." Since there are so many ways to manage, massage, or "engineer" the earnings numbers these days, it is tough to get a handle on a company's real "E."
The only real way to fairly and consistently measure the "E" is via the use of GAAP accounting. But unfortunately, you don't get GAAP earnings when a company reports their quarterly results. And often times you only get a company's "operating earnings," which usually excludes anything bad that occurred during the quarter.
So, if you insist on using a P/E ratio as your market valuation measure, please be sure to use GAAP earnings in your formula. But unless you are willing to create the numbers yourself (which could require digging through each company's earnings report) - good luck with that. (For the record, Ned Davis Research tells us the current S&P 500 P/E based on GAAP earnings is 29.83, which is considered very high given the average since 1926 has been 16.03.)
Getting back on track, while the relative valuation measure using current interest rates suggests that top stocks are VERY cheap right now (mainly because interest rates are at generational lows), our more objective valuation measure using dividends suggests that the S&P 500 is just now getting back to the historical norm.
The last word in the last paragraph also poses a bit of a problem. You see, comparing today's business practices to those of the 1920's doesn't exactly make a lot of sense. And while the concept of paying dividends hasn't changed, the business climate, and as such, the expectations of dividend payments, does change from time to time.
Therefore, it is probably not a great idea to simply look back at the average Price to Dividend Ratio of the S&P 500 since 1925 and draw a conclusion. The current Price to Dividend Ratio for the S&P 500 as of 1/31/09 is 29.1. If we go back to 1925, we see that the average has been 27.0 and that levels over 35 would be considered "expensive" while readings under 18 would make the market "cheap."
However, over the past 50 years the average P/D ratio has been 37.7, over the past 25 years, the ratio has been 47.5 and since 1990, the average has been in the vicinity of 60.
So, are stocks cheap here? To answer the question, you must first pick your time horizon. From 1925, valuations are merely neutral. Over the past 50 years, you can argue that valuations are on the low end of neutral and maybe even at the high end of cheap. And if you are looking out over the past 15-25 years, it is safe to say that hot stocks are indeed approaching bargain levels.
The bottom line is that stock valuations are not expensive at the present time, which is a good thing if you are looking long-term. However, if your time horizon is something more like the start of Spring Break, then you'd best keep your eyes on the banks and what Mr. Geithner may or may not say on the topic.
Wishing you all the best for a profitable week ahead,
ProShares Ultra QQQ ( QLD)
Date Purchased: This is a new purchase
Purchase Price: NA
Buy Strategy: We're looking to add a position here or on any near-term weakness
Active Trader Stop: $22.19
Current Strategy:
It was a relatively quiet week as we've decided to "do less" again in this environment. We did close one winning trade during the week as we sold our recently purchased position in the China ETF (FXI) for a gain of +5.57% in just 3 days. In addition, we cut our position in health care (VRX) in a timely fashion as we managed to avoid a much bigger drop in the best stock (VRX fell an additional -12% after we sold it) in response to Obama's stance on health care was announced. Turning to new trades, we beleive we're setting up for a nice bounce higher and would use any further weakness to start nibbling at the leaders.
STOCK SPLIT REPORT -- by StockSplits.net Editor Jon Johnson
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For post-splits, we can play them as we would pre-splits (very short term), but we prefer to stretch our horizons, playing the trend. When playing options, we look further out, 2 or more months at least. We let the trend carry us along if there is one, but we will also take profits if the technical pattern degenerates, e.g., breaks a trendline. The main difference between post-splits and pre-splits plays is that we really have to like the pattern. Pre-splits can run right before their splits even with poor technical indicators. For post-splits, we are looking at the stocks from more of a longer term "would I buy this stock at this juncture?" position. Now there are times when a hot stock splits and investors pile in to get in while the stock is 'cheaper.' We play those, but with more of a short-term, pre-splits mentality in that we will be ready to get out fast if the momentum fades.
Remember, everything we do has to pass muster with the market that day ... don't fight the market on these plays.
Listen to Stock Split Report Editor Jon Johnson's
stock split interview on CNBC-TV [ Broadband Dial-up ]
Here's a post-split play and our current analysis.
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RIG (Transocean--$59.77; +0.01; optionable): Drilling rigs for offshore oil work.
Company Profile
After Hours: $60.04
STATUS: Flat base. After the selloff RIG put in an 8 week bottoming patter, and broke higher the first week of February, clearing that initial base. It rallied up to the 90 day SMA (59.47) and has slide laterally in a rather flat trading range on low volume. The past two sessions it moved through the 90 day but could not hold the move, closing just below that level. Looking for a breakout on strong volume to show us it is time to buy.
Volume: 8.893M Avg Volume: 10.865M
BUY POINT: $61.65 Volume=13M Target=$69.94 Stop=$57.77
POSITION: RKJ EL - May $60c (52 delta) &/or Stock
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Company Profile
There were many quality stocks in position to lead the market, higher, but the selling over the past three weeks on the lack of a clear bank bailout plan and the rumor becomes fact about the stimulus bill took the majority of those stocks out of their upside patterns. The Chinese stocks, however, given the Chinese stimulus plan that is perceived to be much more effective than that in the US, continued to hold good upside patterns.
BIDU had our attention. It broke higher on 2/9/09, breaking higher from a 7 week reverse head and shoulders pattern on excellent volume. We watched for a pullback to move in and on 2/11/09 it showed a candlestick chart doji right at the 50 day EMA and we put it on the report. Our play is a rebound off of that test. BIDU kept slipping, however. It did not break up its pattern, so we simply adjusted our buy point. On 2/20/09 BIDU gapped higher, clearing the 50 day EMA on a return to above average volume. We didn't chase that gap, but the next session it tested that gap and started back up. That is when we moved into the play with some stock positions at $136.15 and some June $135 strike call options at $23.60 per option. A high price but BIDU runs like the wind and pumps those values up.
BIDU was ready to move after this test. Over the next four sessions BIDU fought the overall market direction, moving up to $153 on the Thursday high. That move took BIDU through next resistance at the 90 day SMA, and it is always nice to clear such a key resistance level. It started to reverse off the high, and with a solid run over the prior six sessions and the poor overall market performance, it was time to take some of the gain off the table. We sold some stock at $151, not at the session high but it banked us a 10.9% gain and beat the closing price at $145.94. We also sold some of our options at $32.40, netting $8.80 per option or 37%. Great upside leadership in a weaker market.
BIDU hung tough, posted a gain back up to $148.32 on Friday after running up close to the Thursday high intraday. We will see how it tests and if it holds that 90 day SMA we will be looking to add some positions on BIDU. The US plan may not work but the Chinese plan is perceived to be working, and as long as it does there will be Chinese stocks such as BIDU, SOHU, ASIA for those wanting to play the upside in a weak overall market.
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