The price to earnings ratio (P/E) is the most common valuation metric applied to stocks. The higher the P/E, the more expensive the stock.
P/E has many shortcomings. The 'E' represents net income as determined by accounting convention. Accounting earnings can be subject to considerable manipulation and often do not reflect the true cash earning power of an enterprise.
Another drawback is that the 'E' typically reflects a 12 month performance window. Company performance is sure to change over time, so basing valuation on a one year time frame can be short cited.
Moreover, Wall Street is notorious for using earnings estimated by analysts for the next 12 months when generating P/Es. Research suggests that analysts are overly optimistic when forecasting the future, meaning that the so called 'forward' P/Es provide an illusion of value that often disappears when P/Es are based on 'trailing' (i.e., trailing 12 month or TTM) performance.
Finally, P/Es often appear most attractive when business cycles have peaked. Cyclical expansions increase earnings. Higher earnings drive P/Es lower, and those lower P/Es can entice investors into thinking that they are buying stocks on the cheap just before cycles turn down. This missive from my friend Vitaliy suggests that we may be facing just such a situation currently.
That said, P/E can still be a useful valuation metric--particularly when employing aggregate P/E measures to assess overall market value. John Hussman is a sharp valuation guy who employs this approach. An example of his work can be found here.
After reading it, answer these questions: Where do we stand currently with respect to overall market P/E compared to history? What is the historical relationship between P/E and future stock returns? What does John Hussman forecast for 10 year market returns given current aggregate market P/E?
position in SPX
Thursday, March 17, 2011
Wednesday, March 16, 2011
Yen Carry Trade
Last nite the Bank of Japan (BOJ) continued to pour 'liquidity' into Japanese financial markets. Total money printing over the past three days has been nearly $700 billion worth of yen. That amount exceeds the objective of the Fed's QE2 program.
At first glance, one would expect the yen to be hammered by this massive wave of money printing. However, the yen is actually higher over the past couple of days.
How can this be? Over the past few years people have been borrowing yen from the BOJ at ultra cheap rates and using the proceeds to speculate in stocks, bonds, and other risky projects. This called a carry trade--borrowing at cheap rates and investing in a project with a higher rate of return. The idea is to make money on the spread between the cost of 'carrying' the cheap loan and the return on the risky project.
The risk to carry trades is that either a) borrowing costs rise or b) returns on risky projects decline. When either occurs, carry traders sell their risky projects and seek to buy back currency in order to pay back their loans and reduce leverage.
Right now, investors want out of risky projects that were funded with borrowed yen. They are effectively short the yen, and to cover their short position they need to buy yen, which is putting upward pressure on price due to higher demand.
Once the urge to close out carry trades sets in, herd mentalities of risk aversion can make this behavior persistent.
It should also be mentioned that carry trades funded by US dollars have increased dramatically over the past couple of years as investors have been exploiting ultra cheap rates offered by the Federal Reserve.
no positions
At first glance, one would expect the yen to be hammered by this massive wave of money printing. However, the yen is actually higher over the past couple of days.
How can this be? Over the past few years people have been borrowing yen from the BOJ at ultra cheap rates and using the proceeds to speculate in stocks, bonds, and other risky projects. This called a carry trade--borrowing at cheap rates and investing in a project with a higher rate of return. The idea is to make money on the spread between the cost of 'carrying' the cheap loan and the return on the risky project.
The risk to carry trades is that either a) borrowing costs rise or b) returns on risky projects decline. When either occurs, carry traders sell their risky projects and seek to buy back currency in order to pay back their loans and reduce leverage.
Right now, investors want out of risky projects that were funded with borrowed yen. They are effectively short the yen, and to cover their short position they need to buy yen, which is putting upward pressure on price due to higher demand.
Once the urge to close out carry trades sets in, herd mentalities of risk aversion can make this behavior persistent.
It should also be mentioned that carry trades funded by US dollars have increased dramatically over the past couple of years as investors have been exploiting ultra cheap rates offered by the Federal Reserve.
no positions
Tuesday, March 15, 2011
Japan's Stock Market Crash
Want to see what a crash looks like? Take a look at the Nikkei (NIKK) in two days.
The NIKK is off 17% since Monday. At one point last nite, NIKK futures were about 25% percent lower.
Domestic markets bounced after opening about 3% lower this morning. Final tally found the S&P 500 down about 1.5%.
Bulls will likely drink this news pretty, and a rally to relieve some pressure may be due. But there may be unfinished business, perhaps a lot of it, to the downside.
In any event, risk management seems the order of the day...
position in SPX
The NIKK is off 17% since Monday. At one point last nite, NIKK futures were about 25% percent lower.
Domestic markets bounced after opening about 3% lower this morning. Final tally found the S&P 500 down about 1.5%.
Bulls will likely drink this news pretty, and a rally to relieve some pressure may be due. But there may be unfinished business, perhaps a lot of it, to the downside.
In any event, risk management seems the order of the day...
position in SPX
Monday, March 14, 2011
SPX 1225ish
Should the downward move in the S&P 500 (SPX) continue, what does chartgazing suggest about significant support below?
Pulling the time horizon back to a 3-4 year frame, important support appears to rest around SPX 1225 (about 60 pts below current levels). This level reflects the intersection of a horizontal and trendline support dating back to the Spring 2009 lows.
If/when we get there, SPX 1225 may constitute a meaningful battleground between bulls and bears.
position in SPX
Pulling the time horizon back to a 3-4 year frame, important support appears to rest around SPX 1225 (about 60 pts below current levels). This level reflects the intersection of a horizontal and trendline support dating back to the Spring 2009 lows.
If/when we get there, SPX 1225 may constitute a meaningful battleground between bulls and bears.
position in SPX
Japan Earthquake Effects
Death tolls from last Friday's catastrophic earthquake in northern Japan have now topped 10,000--a number that is almost certain to rise significantly higher. The country is now working to stave off additional disasters at a couple of nuclear power plants that have experienced reactor damage.
Last night the Nikkei sold off more than 6%. The Bank of Japan (BOJ) injected $200+ billlion billion of 'liquidity' into the financial system in the form of short term money market credit, and asset (bond and ETF) purchases.
In the midst of the BOJ's money printing, the yen actually rallied last nite. As explained here, one reason for this is that there is an immediate need for cash in Japan. People who have have purchases risky assets with yen borrowed at uber cheap BOJ rates (a.k.a. 'the yen carry trade) are now looking buy those yen back to shed risk and whether the economic storm.
Stateside, there has been some fear that Japan might start unwinding its huge stash of US Treasury debt in order to raise more cash. Thus far, the aggressive BOJ monetary actions appears to have stemmed any predilection to liquidate US bonds.
This is a dynamic situation that requires careful watching.
position in TLT
Last night the Nikkei sold off more than 6%. The Bank of Japan (BOJ) injected $200+ billlion billion of 'liquidity' into the financial system in the form of short term money market credit, and asset (bond and ETF) purchases.
In the midst of the BOJ's money printing, the yen actually rallied last nite. As explained here, one reason for this is that there is an immediate need for cash in Japan. People who have have purchases risky assets with yen borrowed at uber cheap BOJ rates (a.k.a. 'the yen carry trade) are now looking buy those yen back to shed risk and whether the economic storm.
Stateside, there has been some fear that Japan might start unwinding its huge stash of US Treasury debt in order to raise more cash. Thus far, the aggressive BOJ monetary actions appears to have stemmed any predilection to liquidate US bonds.
This is a dynamic situation that requires careful watching.
position in TLT
Baltic Dry Index Less Relevant?
Previously we highlighted the Baltic Dry Index (BDI) as a popular indicator of global trade intensity. This missive suggests that the BDI is losing its relevance as an effective indicator.
Not sure I totally buy the argument. For example, the author suggests that changes in the BDI do not correlate well with returns of major cargo carriers. But the author never demonstrates a strong relationship between the BDI and carriers even before the supposed period when the BDI's effectiveness started to wane.
In any event, it's good to keep in mind that some believe that the BDI is becoming a less relevant measure of global trade.
no positions
Not sure I totally buy the argument. For example, the author suggests that changes in the BDI do not correlate well with returns of major cargo carriers. But the author never demonstrates a strong relationship between the BDI and carriers even before the supposed period when the BDI's effectiveness started to wane.
In any event, it's good to keep in mind that some believe that the BDI is becoming a less relevant measure of global trade.
no positions
Sunday, March 13, 2011
SPX Trendline Challenge
It has been said that it's better to draw trend lines with a dull crayon rather than with a sharp pencil, lest one is prone to jump to conclusions about pattern changes.
Such is the current technical state of the S&P 500 (SPX). The uptrend since last March is being challenged. Not decisive enough to confidently conclude that the trend is broken.
But certainly close enough for bulls to be looking over their shoulders.
position in SPX
Such is the current technical state of the S&P 500 (SPX). The uptrend since last March is being challenged. Not decisive enough to confidently conclude that the trend is broken.
But certainly close enough for bulls to be looking over their shoulders.
position in SPX
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