Why Are P/E Ratios So High?

Over the years the average P/E ratio for stocks in the S&P 500 has been between 13 and 15. When earnings go up the P/E ratio goes down. Investors buy and the P/E ratio comes back up. But, why are P/E ratios so high today? Tesla has a P/E ratio of more than 1,000. Amazon has a P/E ratio of 120. Netflix has a P/E ratio of 83. Apple has a P/E ratio of 17. Why are P/E ratios so high for Netflix and Tesla? The reason is that enough investors believe that Tesla will become the dominant company in the electric car industry and that Netflix will dominate the streaming content niche. In addition, with interest rates at historic lows, even over-priced stocks can look attractive.

Disadvantages of Using P/E for Valuation

During a bear market the P/E ratio of a stock may be misleading. When we consider the intrinsic value of a stock, we look to the future and not the immediate present when the business cycle has slowed down. And, a steadily growing stock that is coming to dominate its market niche will typically have a high P/E ratio as investors want to get in before the price goes even higher. But, if a company is really failing and its stock price is falling, the P/E ratio may mislead investors into thinking that the stock is stable.

P/E and PEG Ratio

When you are factoring growth into the equation for a stock, the PEG ratio can offer more insight than the P/E ratio. The PEG ratio is the price and earnings to growth ratio,

PEG = (P/E ratio/Annual Growth Rate)

In the best of all possible worlds, the PEG of a fairly priced stock should be one. Market Watch writes about the “three stock markets” and warns that FAANG stocks with high P/E ratios are overpriced, stocks traded by the Robinhood investors are crazy, and the rest of the market has value if you can find it. Their observation is that the P/E ratio makes sense in the broader market while the FAANGs are priced too high and the choices of most Robinhood investors make little or no sense.

If you are interested in a stock like Tesla, a better approach than the P/E ratio is to compare their progress to that of companies like General Motors, Ford, and Volkswagen. The winners in the race to dominate the electric car market will necessarily be the ones that are flashy today but the ones who are most efficient and profitable in the long run.

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Safe Investments if the Pandemic Gets Worse

The Motley Fool suggests three stocks to buy ahead of a potential second wave of the virus. They are PayPal, Logitech, and Quidel.

PayPal has nearly doubled its stock price since the beginning of the year from $102 a share to $198. They are benefitting from the wholesale move of commerce online.

Logitech is a computer hardware maker that has also benefitted from the move of business and social activity online and from home. They have seen a nice stock price increase from $47 to $74 a share.

Making Covid-19 Tests is Profitable During the Pandemic

Quidel’s stock has gone from $74 a share to $241 a share since the first of the year. These folks make tests for Covid-19! Our opinion is that this company is in the best position of the three to do well if the pandemic worsens this fall. Their Lyra SARS-CoV-2 rapid assay test got emergency use authorization from the FDA in March and their Sofia 2 SARS Antigen FIA test that produces results in fifteen minutes was approved in May. As the Covid-19 virus reemerges as a problem across Europe, the UK, Japan, and other countries that had seen it subside, there will be a need for more testing across the globe. As the pandemic continues to grow out of control in the USA, the need in North America will be even greater. In the coming months and into at least 2021 one can expect to see Quidel to be a safe investment as the virus continues to be a major problem.

Other companies that make Covid-19 tests include Roche, Abbot Labs, and Thermo Fisher. However, these are larger companies for whom the benefit of making a Covid-19 is diluted by the success or failure of their other products and services.

How Long Will Covid-19-related Profits Last?

Companies that make tests for the Covid-19 virus and those that are developing vaccines are going to make money in the coming year or so. But, this may be a one-time occurrence no matter how dire the need is right now. If it turns out that the Covid-19 virus keeps mutating, there may be the need for vaccinations every year. Then, it will essentially be another “flu” shot. This can be a good business but not something exceptional. Thus, the companies like Quidel that are money-makers now will probably cool off in a year or two.

Safe Investments if the Pandemic Gets Worse – Slideshare

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Should You Hold Your Investments Forever, or Not?

Buffett has been quoted as saying that when he purchases stock in a strong company with strong management that favorite length of time to hold that investment is forever. And now, according to the most recent Berkshire Hathaway quarterly report, they are holding $122 Billion in cash while in normal times they would be holding something like $30 Billion. This is because in almost four years Berkshire Hathaway has not made any major stock purchases or acquisitions. And, in the first two quarters of this year, Buffett has be a net seller of stocks. The two parts of intrinsic stock value are the likelihood of a stock making money over the years and the current price of the stock, or any investment. What is happening with Buffett’s company is that they are not seeing any investments these days that combine growth and money-making potential with reasonable or low prices. This is the silent warning for investors.

Why Is Buffett Not Buying Back as Much Berkshire Hathaway Stock?

A third piece of the silent warning for investors is that Berkshire Hathaway has reduced its stock buybacks as well. Buying back your stock is done to increase share price and put excess cash to the best use possible. According to company reports, stock buybacks went from $1.7 Billion in the first quarter to $400 Million in the second quarter. We recently wrote about the potential dangers of stock buybacks. In the case of Berkshire Hathaway, the company has not been trying to artificially raise its share price and has rather been putting its cash to the best use. The fact that they are now keeping a large hoard of cash implies that the “better use” of this money will be in invest in the near future after a substantial market correction or even a crash. The likelihood of the trade war becoming permanent is such that smart investors will do well to hold a large amount of their portfolio in cash until the future becomes clearer and until the prices for stocks and other investments become more realistic.

Amazon, Netflix and Microsoft together this year are responsible for 71 percent of S&P 500 returns and for 78 percent of Nasdaq 100 returns.

The three stocks make up 35 percent, 21 percent and 15 percent of S&P 500 returns, respectively, while making up 41 percent, 21 percent and 15 percent of Nasdaq 100 returns.

While some companies in the S&P 500 are simply appreciating less rapidly than the tech darlings, others are losing ground. The best performers are those with the best and reliable earnings quarter after quarter. The question for the wary investor is how to spot overpriced investments in this mix. In this regard, Market Watch says that the average stock is overvalued.

The offer three charts, all of which demonstrate that the market is flirting with the sort of valuations that preceded the 1929 crash that ushered in the Great Depression, the Dot Com crash, and the 2008 crash that gave us the Financial Crisis and the Great Recession.

The three charts show three things. First, the market is trading about 70% above its historic mean and this has only happened before in the days preceding a crash. Second, the total stock market cap compared to the US GDP is also at a historic high seen only in the days prior to previous market crashes. And, third, the prices of stocks are excessive in relation to the so-called “replacement” value of the companies. This is the Tobin Q ratio. In order to avoid being badly hurt when the market eventually corrects, smart investors can use any or all of these approaches to decide what investments to hold and which to sell.

Margin of Safety

We mentioned that the leading stocks in the S&P 500 are there because of continued great earnings. But, which of these companies is vulnerable to a significant reduction in earnings in the event of a recession. And, which of them has a margin of safety to protect them in the event of a downturn. A margin of safety can be money in the bank or tangle assets like property and factories that are unencumbered by debt. A margin of safety can also be a business whose products and services will not be significantly affected by an economic downturn.

Microsoft has about $82 billion in long term debt. It is also the only US company, besides Johnson and Johnson, to have AAA bond rating. Microsoft also has about $134 billion in cash. Apple has about $97 billion in long term debt and about $244 billion in cash on hand. Both of these companies have significant margins of safety in case of a financial downturn. The question is what happens to their revenue if the economy tanks? Microsoft is no longer so dependent on its Windows software for profits but Apple still needs to come up with the better and more impressive set of smartphones and tablets every year or so.

A margin of safety issue that is appropriate to how to spot an overpriced investment is that both of the companies are in a “high cost of entry” business. This is to say; the development of patents, product lines, and internal skill sets is such that there would be an almost insurmountable cost to replicate either business. This is where Tobin’s Q ratio comes into play. To the extent that a business controls an irreplaceable niche in the tech world, they are protected against financial devastation in the event of a market correction. One of the ways to spot an overpriced investment is to use this sort of analysis or approach.

How to Spot Overpriced Investments PPT

“You could be looking at the first 20 percent-plus decline in the S&P since the financial crisis,” the firm’s chief U.S. strategist said Tuesday on CNBC’s “Futures Now.”
His worst-case scenario is a 30 percent plunge next year.

“Our primary list of concerns is on the earnings front,” Clissold said. “Earnings growth north of 20 percent isn’t sustainable, especially when you’re nine years into an economic expansion.”

Clissold, a secular bull, isn’t calling for a major, drawn-out recession. Nevertheless, he said he’s on bear market watch due to warning signs indicating a tired bull market.

So, could your investments lose 30% next year due to a tired bull market, trade war, and wavering investor sentiment? What kinds of investments are at risk? And what are safe investments to hold today?

Safe versus Risky Investments

Any stock that is still going up in price based on investor optimism needs to also have strong intrinsic value or it will end up causing a 30% loss or worse. Last spring we asked what can you invest in and not get hurt by a trade war.

Of late we have written about switching investment focus from growth to value as we have been ruminating about the possibility of a stock market crash, economic recession, and collapse of the real estate market, all caused by a trade war. Materials stocks have been hurt by Trump’s announcement of tariffs on steel and aluminum. The bull market has been historic and is likely to cool off if we are lucky and collapse if we are not. How can you invest and not get hurt by a trade war?

Companies that get their raw materials locally and do business primarily in the USA are largely immune from the effects of a trade war. Biotech is also largely protected because when someone comes up with a cure for diabetes or cancer it will be a money maker no matter what else is happening.

Companies with lots of business in China, Europe, Mexico, and Canada are at risk as are companies that get their raw materials from any of these regions. Boeing stands to lose badly if foreign buyers move in bulk to purchase jets from Airbus. Apple gets nearly two thirds of its revenue from offshore and 30% from China. Likewise, Ford has a large offshore presence that could be hurt in a trade war. A larger issue for a company like Apple is that it manufactures many of its parts offshore making them subject to tariffs.

Could your investments lose 30% of their value next year? If you are not sure about how to deal with the possibility of a market correction, consider how to invest without losing money while the economy, trade issues, and the markets are sorting themselves out. A well balanced investment portfolio commonly includes high grade bonds to protect against exactly this kind of risk.

Could Your Investments Lose 30% of Their Value Next Year? PPT

Their point is that while many factors drive the market, forced buying is a real driver when huge pension fund contributions roll in, usually on a quarterly basis.

Downside Risk in Offshore Tech

Reuters writes about a similar problem in tech companies in emerging markets.

The boom in emerging market technology stocks is becoming a problem for fund managers of all stripes.

The soaring market capitalization of a handful of companies such as China’s Alibaba (BABA.N) and Tencent (0700.HK) is steadily lifting their weighting in the MSCI emerging equities index .MSCIEF.

This means investors in funds that track indexes (exchange traded funds or ETFs) – who want exposure to a range of companies for a lower fund management fee – are finding themselves increasingly exposed to a single sector.

Meanwhile, active fund managers, who justify charging higher fees for their individual stock-picking expertise, are under pressure to buy those tech stocks to ensure their funds keep up with the index’s gains.

And with both sets of investor chasing the same thing, the risk of dramatic outflows increases if the sector falters.

The increasing values in the tech sectors both at home and abroad are a problem. Add to this a lot of money such as from pension funds pouring in and there is a risk of excess. In general when someone has made handsome profits from a stock run up they may take some money out of that winner and put it into something solid and safe. But if the solid and safe stocks are not making any money the temptation is to leave money in the winners, until they crash!

Active versus Passive Investing

We wrote recently about passive versus active investing.

The longest bull market since World War II has been driven by these big cap stocks: Facebook, Apple, Amazon, Microsoft, Google and Johnson & Johnson. When the time comes for a correction involving these market leaders investors will look elsewhere for profits and that will be the work of active investing and use of fundamental analysis of individual stocks. Active investing is more work than passive but when passive investing loses money active is your only choice.

While simply buying a tech ETF has been profitable for years that situation will probably not last forever or perhaps even through the rest of 2017. Smart investors track their investments using the principle of intrinsic stock value. The main factor is projected earnings but also this calculation requires that your compare the intrinsic value with the current price. When intrinsic value consistently lags market price, the market price will eventually correct. Even if pension fund money is keeping the rally alive for now you can think ahead and adjust your portfolio in advance of a market correction.

Is Pension Money Keeping the Rally Alive? DOC

Is Pension Money Keeping the Rally Alive? PDF

Is Pension Money Keeping the Rally Alive? PPT

If the man often hailed as the original “Dr. Doom” is right, the stock market could see another “lurch” higher – at which point investors may want to cash out quickly and run for cover.

Marc Faber, the editor of “The Gloom, Boom & Doom Report’ and a perennial bear, isn’t backing down from his latest dire prediction that would send stocks plummeting by 40 percent or more.

A drop of that size could take the S&P 500 Index down from Friday’s closing price of 2,438 to 1,463.

Mr. Faber is basing his prediction on the narrowness of the rally with so much capital thrown at so few stocks, namely the FANG tech stocks. The bright side, he says, is that when market bottoms out there will be plenty of bargains to pick up. So, what do others think?

Up, Down, Up and Finally a Crash

Investing.com writes about one possible scenario for a stock market crash.

After 8+ years of phenomenal gains, it’s pretty obvious the global stock market rally is overdue for a credit-cycle downturn, and many research services of Wall Street heavyweights are sounding the alarm about the auto industry’s slump, the slowing of new credit and other fundamental indicators that a recession is becoming more likely.

Few have taken the risk of projecting a date for the crash. Next February is a good guess, as recessions and market downturns tend to lag the credit market by about 9 months.

Read the article and follow his somewhat complicated graph and reasoning. A salient point in that he makes as that while the naysayers get rolled over with each successive market advance their warnings are remembered. Unfortunately everyone remembers at once at the top of the advance and massive selling becomes a self-fulfilling prophecy driving the market into a crash.

Who Else is Worried?

The Guardian writes that a steep rise in lending has caused worry at central banks.

World leaders have been warned to guard against another financial crash after a steep rise in risky bank lending over the past year that could threaten the stability of the global financial system.

The international body that represents central banks said a recovery in global trade this year and improving levels of GDP in most countries could create complacency and convince policymakers to ignore warning signs of excessive lending coming from the financial sector.

With only two weeks until the G20 summit of world leaders in Hamburg, the Bank of International Settlements (BIS) said politicians and central banks needed to keep financial markets in check to prevent another crash.

In the aftermath of the Great Recession it was China’s bet on growth and borrowing for expansion that helped support the global economy. Now that China has cut back on raw material imports many emerging economies are hurting and as China continues to pile on debt they may assume a role opposite the previous and drag the world economy down with them!

Is Dr. Doom Right about the Markets? DOC

Is Dr. Doom Right about the Markets? PDF

Is Dr. Doom Right about the Markets? PPT

Rising bond interest rates are sapping the popularity of high-yielding stocks.

For the first half of the year, the S&P 500 sectors most sensitive to interest rates seemingly traveled in only one direction: up, drawing both institutional and mom-and-pop investors to the stock market to buy telecom, utilities and real estate investment trusts, known as REITs. The appeal was their high dividend yields.

But in keeping with Isaac Newton and his theory on gravity, the darlings of the 2016 markets have fallen back to earth.

Rising interest rates explain the faltering of dividend stocks but what else is going on?

Is There a Trump Speed Bump Ahead?

The stock market anticipates gains and losses in stock prices. CNN Money writes about a potential speed bump for the stock rally.

Trump’s victory led to an explosive rally in stocks of financial, health care and industrial companies.

Investors are betting Trump and the Republican-led Congress will roll back some Wall Street and health care reforms put in place under President Obama, cut taxes and approve $1 trillion in stimulus for roads, bridges and other infrastructure.

But has the stock rally gone too far too fast?

It may be that the so-called Trump bump has already eaten up potential gains for 2017. For the market to maintain and move ahead next year the market needs to perform despite higher interest rates. Trump needs to deliver on his promises which will mean making congress go along. And we all need to hope that the new president does not start a trade war that extinguishes global as well as US economic growth.

A Voice of Concern from the Heartland

Mr. Trump won the election despite winning less than half the votes because he dominated in states across America´s heartland. Now the same folks who voted for him are concerned about the price of a trade war with China. The Delta Farm Press discusses the issue.

The late President Dwight Eisenhower had a sign in his office on his farm in Gettysburg, Pa., that said: “Farming looks mighty easy when your plow is a pencil, and you’re a thousand miles from the corn field.”

The same might soon be said about trade negotiations, a subject that could play an increasingly important role in whether U.S. farmers are able to enjoy higher prices for their crops in the near future.

Trump named Peter Navarro, author of the book, “Death by China,” and a frequent critic of China’s economic policies, to head the newly formed White House National Trade Council, removing any doubts that he intends to take a tough stance on relations with China.

The two primary objects of retaliation by China in a trade war would be the two largest exporters, Boeing and U.S. agriculture. The agricultural states in the heartland are the ones who voted Trump into office. What is happening to the stock market rally is that investors may be waking up the concerns of farmers, Boeing and defense contractors who seem to be on Trump´s hit list.

What Is Happening to the Stock Market Rally? DOC

What Is Happening to the Stock Market Rally? PDF

What Is Happening to the Stock Market Rally? PPT

Even while some Wall Streeters are saying Donald Trump’s presidency could result in stronger domestic growth and a boost to the stock market, a team of Goldman Sachs GS 0.03% analysts led by top strategist Charles Himmelberg are saying, “Not going to happen.”

Stocks already look expensive from a historical perspective, the team says. And Donald Trump is not going to help the matter. As a result, the Goldman analysts are expecting the S&P 500 Index to close at 2200 in 2017-just 18 points, or higher than where it is now. Goldman also expects the price of the U.S. 10-year Treasury bond to drop 0.50% in 2017. The yield, which moves in the opposite direction of price, will end the year up at 2.75%.

The argument behind this opinion is that there are structural factors that are not addressed by Mr. Trump’s plans. There are not enough workers to fill all of the jobs that Trump envisions. Thus the result of more jobs will not be more productivity, profits and higher stock prices but rather increased competition for skilled workers and wage inflation. If Mr. Trump follows through with deporting more willing workers from the USA that will further reduce the pool of available workers.

“We are skeptical,” the team wrote. “Until more clear evidence accumulates showing that the outlook for productivity and trend growth has improved, the opportunity set for investors is likely to remain low.”

All the hyperbolic rhetoric in the world will not keep the already overpriced market from being a huge disappointment in 2017.

Is There Any Hope for Stock Gains in 2017?

The Goldman Sachs analysis has to do with the market in general and certainly applies if you are going to put your money in an index fund that tracks the S&P 500. But are there sub segments of the market that will do better? The Wall Street Journal says that small beats large when looking at the next few months in the market.

Small companies have been among the biggest winners since Election Day.

Investors betting that Donald Trump will roll back regulations and taxes while pumping money into infrastructure projects have driven the Russell 2000 index of small-capitalization stocks to 11 straight sessions of gains Friday, its longest winning streak since June 2003. The index has risen 10% since Election Day, outpacing the S&P 500’s 2% climb.

Hopes for a pro-business combination of a Trump presidency and Republican Congress have lifted stocks broadly. But some analysts think smaller companies could benefit even more, because they are less exposed if Mr. Trump takes a more protectionist approach to trade and if the dollar continues to rise. Either development, along with the growing backlash against globalization as seen in the Trump and Brexit votes, could hurt multinationals and leave smaller, domestic companies relatively better off.

Smaller and domestic stocks may well be better choices if the overall 2017 stock market turns out to be a huge disappointment.

Will the 2017 Stock Market Be a Huge Disappointment? PPT

Wall Street declined in late morning trading on Wednesday, with the tech-heavy Nasdaq composite falling more than 1 percent after disappointing results from technology giants including Apple, the world’s largest publicly traded company.

Apple (AAPL.O) shares slumped as much as 6.7 percent to $121.99, a day after the iPhone maker’s revenue forecast for the fourth quarter fell below expectations.

The stock was the biggest drag on all three major indexes and contributed 40 points to the Dow’s overall decline.

Microsoft (MSFT.O) fell as much as 4 percent to $45.35 after reporting its biggest quarterly loss, as the company wrote down its Nokia phone business and demand fell for its Windows operating system.

Yahoo (YHOO.O) was down 1.4 percent at $39.18 after it forecast lower-than-expected revenue for the current quarter as it struggles to revive its core online advertising business.

What happened to Apple seems to be what happened to other tech stocks. Analysts expected bigger earnings and were disappointed. Microsoft was among the losers due to a write down on its purchases of the cell phone of Nokia. What happened to Apple, however, may continue to happen and the history of Microsoft is instructive.

Microsoft

Microsoft went public in April of 1986. It steadily grew and peaked at $60 (adjusted for prior and subsequent stock splits) in 1999. The stock has appreciated 600 fold at its peak prior to the dot com bubble collapse. It fell into the $20 range where it stayed for over a decade. Although it how trades in the $40 range Microsoft is done with its growth years. In fact, there are concerns that Microsoft will not be able to compete in the hand held device market with Google and Apple. The point is that Apple, and Google, have experienced phenomenal growth, like Microsoft, are perhaps due to level out and disappoint analysts. That, perhaps, is what happened to Apple. Apple may need to follow the example of Microsoft and remake itself to maintain its position. Seeking Alpha suggests that we buy Microsoft.

While the sell-side analysts are constantly obsessed with companies meeting quarterly targets, from a long-term perspective, Microsoft is doing everything it needs to do to position itself for future growth. Downsizing and restructuring its phone business is the proper course of action as is shifting focus toward the cloud.

As a result, I remain very bullish on Microsoft, and if anything, investors should use this drop as a buying opportunity.

What happened to Apple was that investors expected too much. This may become a recurring phenomenon and then Apple will need to reinvent itself, again.

Can They Sell Enough Watches?

Although Apple earnings missed expectations sales of the Apple watch were said to have exceeded company expectation although the company was not specific about the results. But Time offers and informed opinion about Apple watch sales.

Apple posted its third quarter earnings on Tuesday, and, as expected, it didn’t give any precise numbers regarding Apple Watch sales so far. It did, however, give us enough data to make a viable back-of-the-envelope guess.

In its latest earnings reports, Apple has broken out the Units Sold and Revenue Made for several different product categories: iPhone, iPad, Mac, “Services” (iTunes, AppleCare, Apple Pay, etc.) and “Other” (formerly Apple TV, iPod, etc). This time around – Apple’s first earnings report in a post-Watch world – Apple included the Apple Watch in “Other.” That hides the Apple Watch’s performance to some degree – but only a little.

A billion dollars in revenue is a good thing but does not make up for losses in other product lines. Nevertheless Apple has billions socked away and can weather any immediate storms. The question is how long can Apple keep growing when it already has the highest market cap?

What Happened to Apple? PPT