Stocks May Not Be Cheap Enough Yet – and Here’s Why
Archives: Daily Issues
Issue #2589
- WEALTHY: 3 elements of a winning stock (Keith Fitz-Gerald)
- HEALTHY: Burn calories faster (Kelley Herring)
- WISE: Fred Adler on happiness
ALSO IN THIS ISSUE:
- How to get nowhere fast (Bob Cox)
- Make your proof more powerful (Jason Holland)
- It’s Good to Know… about Ben Franklin and “early to rise”
- Add “censure” to your vocabulary
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“Happiness is a positive cash flow.”
Fred Adler
Stocks May Not Be Cheap Enough Yet – and Here’s Why
For many investors, a low price/earnings ratio (P/E) is a sign of value.
But don’t you bet on it – at least, not yet.
According to Michael T. Darda, Chief Economist for MKM Partners LLC, stock analysts have overestimated earnings by an average of 30 percent to 35 percent in the last three recessions. For millions of investors who use low P/E ratios as a litmus test for selecting stocks, that’s got to be a rather unpleasant shock.
If Darda is right, and our research seems to suggest he is, so-called “cheap stocks” may not be all that cheap. For proof, we can turn to some plain old high school math.
P/E ratios are calculated by taking the price of a stock (the numerator, or the “P”) and dividing it by earnings per share (the denominator, or the “E”). The higher the denominator, the lower the P/E ratio – and, by implication, the cheaper a stock appears to be.
However, if higher denominators can make stocks appear “cheap,” the opposite is also true. And that suggests stock prices may have a lot farther to fall – despite the fact that they’ve already tumbled 40 percent or more.
Just how much farther is anybody’s guess, but the outlook is not good.
For instance, according to Forbes writer James Clash, “more than a year into the market downturn that threatened Morgan Stanley’s survival, the 17 analysts covering the company cut their 2009 mean earnings estimates by 36 percent to $3.63 per share.” Given Darda’s observations, there may be another 35 percent to go, which would put total expected earnings cuts at 71 percent.
That sounds harsh, but it may not be out of line. Financial information provider Thompson IBES reports that the analyst community as a whole has cut 2009 earnings expectations by only 7.5 percent for the Standard & Poor’s 500 Index. If they are to be believed, that means the analyst community expects the average S&P 500 company will have to grow earnings by 15 percent next year to $91.
I don’t know about you, but at a time when recessionary flags are flying, I have a hard time buying that. (Pun absolutely intended.)
That’s why I want to point out that analysts are paid to have opinions – and a huge body of evidence suggests that they’re strongly encouraged to make them bullish. Not only is this a cozy relationship for investment bankers in general, it has historically helped Wall Street generate huge commissions from an anxious investing public that is desperately seeking good news. This bullish predisposition may be especially true at a time when investors are not inclined to buy – and with good reason.
Compounding the problem is the fact that many analysts who focus on specific industries or companies tend to become quite myopic. Far too many don’t think outside the box and, as a result, are all too frequently surprised when macro-level events come crashing in on their little world and down on the companies they follow.
Investors who rely heavily on Wall Street analyst estimates are, in effect, driving down the highway using only their rearview mirror. The results are all too predictable.
Among the more infamous examples: the group of analysts who, back in 2001, continued to recommend Enron Corp. stock all the way into bankruptcy and congressional hearings, based solely on their own “optimism.” Only when Enron shares were trading at less than $1 did the majority of analysts change their recommendations to a “hold.”
When it comes to Wall Street, the fox clearly does guard the financial hen house, so to speak.
In the interest of fairness, I should mention that there were “accounting irregularities” in the Enron case. But that really shouldn’t let anybody off the hook.
What’s happening now – and why I’m leery that things may not be as they seem – is that overall business and economic conditions are deteriorating faster than management is willing to publicly acknowledge. (Although we’re now watching these same management teams slash workforces and shutter plants at a rate we haven’t seen in years.) And since management “guidance” (the sarcasm you detect is intended) is what drives and shapes Wall Street earnings estimates, this is why things are probably going to get worse before they get better. The earnings figures used in most P/E calculations haven’t yet been reduced.
As for the ratings agencies – such as Standard & Poor’s, Moody’s Investors Corp., and A.M. Best Co. – these, too, are problematic when it comes to the earnings and the ratings that help drive them. Supposedly independent, it’s been common knowledge for years on Wall Street that firms wanting higher ratings need only coddle the agencies by using a combination of fees and information. Of course, the agencies will deny this – but history suggests that’s like the pot calling the kettle black.
Historically, for example, Moody’s, S&P, and Fitch Ratings Inc. have each earned huge amounts of income from fees paid by the issuers whose credit they’re supposedly rating. That’s changing. But, as the credit crisis has highlighted so aptly, probably not fast enough.
So what does work?
P/E ratios are a start. But that longstanding indicator should be regarded as a relative measure of potential price and performance.
When I analyze a company, I prefer to see expanding sales, advancing earnings, and plenty of cold hard free cash flow. There’s an old saying on Wall Street that “nobody ever went broke on accrual accounting.” But, clearly, plenty of companies have figured out lately that they can go broke without cash. The best example may well be Detroit’s Big Three, which are grappling with this seemingly new reality even though we, as individuals, deal with it every day.
One other excellent indicator is a “PEG” ratio (the P/E divided by the growth rate) of less than 1.0. While it’s more commonly viewed using 12-month trailing earnings, it’s much more stable when viewed against a historical stream of data that’s a decade or more in length. Not only does this help screen out the volatility associated with much shorter time periods, but companies with low PEG ratios calculated in this manner seem to represent good value over the longer term.
Especially when compared to a deflated “E” – earnings.
[Ed. Note: The ongoing financial crisis has changed the investing game forever, making uncertainty the norm and creating a whole set of new rules that will help determine who wins and who loses. Investors who embrace this change will not only survive - they will thrive.
Keith Fitz-Gerald - Investment Director of the Oxford Club's top-rated Money Morning newsletter - has already isolated these new rules and has unlocked the key to what he refers to as "The Golden Age of Wealth Creation."
Fitz-Gerald's cutting-edge investing advice also appears in ETR's Liberty Street Letter. Discover how you could recover your recession losses by September 30, 2009 by signing up for this exclusive dispatch right here.]
Ready to Recoup Your Recession Losses By 9/30/09?
I don’t know about you, but I’d barely trust Wall Street and the Big Banks with the 63 dollars in my wallet right now, never mind my IRA, 401(k), and life savings!
That’s why thousands of smart Americans are now taking matters into their own hands and quietly moving their savings and portfolio “off” Wall Street… to a far safer and more profitable place I call “Liberty Street”.
One “Liberty Street” investment of as little as $1,000 has the realistic ability to quickly swell into a full year’s salary in as little as a few weeks time – and then repeat over and over again.
Another “Liberty Street” opportunity is currently offering the chance to gain year-in and year-out returns of 65% with 99.77% certainty – even in today’s economy.
The Evil Twin of Procrastination
By Bob Cox
I’ve noticed that almost every time I’m in a hurry, something bad happens. And the rushing around is often the result of the time pressure that follows procrastination.
Say your goal is to advance within your company. A management position recently opened, and you decided to submit your resume. However, you procrastinated… and didn’t turn it in until the last minute. In your haste, you didn’t take the time to “proof” your submission. And by not doing so you left in several misspelled words.
Oops! Now you know why you weren’t considered to be the top candidate.
Don’t let rushing or impatience interfere with the achievement of your goals. Learn how to recognize when you’re in too much of a hurry, and slow yourself down.
I have two warning signs that trigger me to slow down:
- I have an inner sense of desperation.
- I become irritable – and this affects my judgment.
Both of these warning signs occur when my timeframe to complete a task or project becomes compressed to the point where I can feel myself speeding up the process. A sense of urgency is acceptable. But a sense of panic isn’t. That’s when I know I have to step back, take a deep breath, reset myself, and focus.
You must discover your own warning signs and resist the urge to rush. Stick with routines that work. And don’t make things worse by procrastinating.
[Ed. Note: Success mentor Bob Cox - who has worked with four billionaires during his career - strongly believes that setting goals can help you make your longest-held dreams come true. Learn proven goal-setting and achieving strategies from Bob right here.]
The Wikipedia Defense
We’ve talked, before, about the risks of using Wikipedia as a research resource. You just can’t be sure that whatever random person decided to create an entry knows what he’s talking about… or that he doesn’t have an agenda or ulterior motive for spreading disinformation.
That’s why I was dismayed to see Wikipedia cited as a primary source in a commercial for a law firm.
They were soliciting potential clients who have a type of lung cancer – mesothelioma – thought to be caused by exposure to asbestos. The commercial listed the causes and effects of the disease. And after each one, the words “Source: Wikipedia” popped up.
This is a serious disease that is killing people. And I’m sure many of them deserve compensation from employers whose negligence exposed them to asbestos. But whoever put together this commercial is crazy. Couldn’t they find a reputable study from a university or government agency? What about the U.S. Department of Health, the Centers for Disease Control, or the National Institutes of Health?
In other words, couldn’t they find PROOF to lend credibility to their claims?
According to Michael Masterson, a good advertisement – one that will create in your prospective customer an irresistible urge to buy – should have four things: a benefit, an idea, credibility, and a track record.
Without credibility, any ad is almost worthless. And as a reliable source, Wikipedia doesn’t fit the bill.
No promotion goes out the door here at ETR without that essential element of proof. And neither should any of yours.
Whenever you make a claim, back it up with facts and figures. And make sure they come from a reputable source. If your product or service is good, this should be no problem. If you can’t find trustworthy back-up, it’s time to go back to the drawing board.
[Ed. Note: Three of today's top ad writers and businessmen have dissected the teachings of an advertising legend. A man directly responsible for over $2 BILLION in sales, working just four hours a day. You can quickly learn his secret techniques and apply them however you wish. Get the details here.]
An Exercise Combo for Faster Results
Want to see faster weight-loss and fitness results? Do a combo!
A recent study published in the Journal of Sports Science and Medicine found that men who combined aerobic exercise with weight training for 16 weeks ate significantly fewer calories compared to men who did aerobics or weight training alone or who did no exercise at all.
And of course, eating fewer calories and burning more fat makes for a leaner, fitter you.
The researchers believe that the combo of cardio and strength exercises works by improving blood levels of fats, glucose, amino acids, and satiety hormones.
Get on the fast track to health by coupling this exercise combo with a low-glycemic, “clean” protein diet packed with antioxidant-rich fruits and veggies to fuel your fat-burning machine.
[Ed. Note: Staying fit is a two-part process. For expert advice on how to eat better and plenty of easy-to-follow exercises you can do at home, sign up for ETR's natural health e-newsletter.
Get a head start on eating right with nutrition expert Kelley Herring's Guilt Free Desserts recipe e-book. Pick up your copy here.]
It’s Good to Know: Ben Franklin and “Early to Rise”
Hold on to your hats, Early to Risers. Turns out Ben Franklin, our “patron saint,” did not coin the adage “Early to bed and early to rise makes a man healthy, wealthy, and wise.”
Franklin gets credit for popularizing it in his Poor Richard’s Almanack. But, according to scholar Wolfgang Mieder, a variation can be traced as far back as 1496, in a book on fishing. The first use of the saying as we know it today was in 1639, in a collection of popular proverbs. That predates Franklin by more than a hundred years.
Franklin freely admitted that he wasn’t the originator of the majority of the inspirational sayings in the Almanack. He merely collected quotes that reflected his personal philosophy of life and would be helpful to his readers. However, over the years, Franklin’s name became so attached to “Early to bed… ” that people came to believe he came up with it himself.
Thanks to ETR contributor Don Hauptman for bringing this to our attention. But it merely confirms what we’ve said many times. Most good ideas are not original. They are revisions, combinations, or variations of existing ones. So even though he may not have been the first to express this idea, we’re sticking with Ben.
(Source: Proverbs Are Never Out of Season)
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Word to the Wise: Censure
To “censure” (SEN-shur) – from the Latin for “censorship/judgment” – is to find fault with and condemn as wrong.
Example (as used by Mary McGarry Morris in Fiona Range): “She was tired of their disapproval, the silent censure, their eagerness always to assume the worst.”
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Copyright ETR, LLC, 2009
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