Progress Principle. Stocks rallied yesterday in response to word that progress is being made in US – China trade talks. Stocks started yesterday’s session in the green following positive overseas moves which began in Asia as investors’ hopes for some resolution on trade increased. Though the rally faded at one point nearly zeroing out gains, stocks turned around and rallied steadily into the close. Yesterday marks the third day in a row of gains for stocks following a solid jobs number and Jerome Powell’s market-friendly talk. Throw in the prospect for a positive outcome on trade and you get what many are hoping to be the beginning of a trend. Despite all of the positive sentiment, which is most likely short term, the real reason behind the positive move in the market is most likely related to the time of year and the fact that stocks are cheaper as a result of the dismal end to 2017. In other words, investors need to buy and there is lots for sale. More on that in a minute. The S&P500 rose +1.0%, the Dow Jones Industrials advanced by +1.1%, the Russell 2000 traded up by +1.51%, and the NASDAQ 100 rallied by +0.98%. Bonds traded off yesterday as capital flowed from safe havens into risk assets leaving the ten year yield to maturity around 2.73%, an increase of +3 basis points. Crude oil edged closer to the $50 mark rising +2.6% to $49.78 a barrel. Though the recent positive moves in crude have helped the broader markets consolidate and advance (particularly the energy sector), there will be a point soon in which some might look at the rise in crude as having an impact on inflation (particularly the now-percieved dove-ish Fed). Both the S&P500 and Dow have advanced above key Fibonacci resistance levels (38.2%) while the Russell and NASDAQ are not far behind. All indexes remain risk off. Now back to stocks being cheap. What does that mean and how do we know that? There are many ways to come up with a fair value for a stock but perhaps the most common and simplest one to describe is the earnings multiple, or P/E ratio, and because it is geek-out Wednesday I think it is a good time to discuss P/E further.
The price to earnings ratio is perhaps the most highly utilized valuation method and is broadly quoted on a daily basis. It is also referred to as the earnings multiple or price multiple. Generally it describes how much an investor is willing to pay for $1 dollar of corporate earnings. So if a company has a P/E of 15x, it can be said that investors are willing to pay $15 for $1 of earnings. Though there are several variants of the P/E, the three most common methods are trailing P/E, forward P/E, and PEG (P/E growth ratio). The trailing P/E is the most common and is typically calculated using the past 4 quarters of earnings. It is calculated as follows:
P/E Ratio = ( Price / Earnings Per Share )
Price = the share price on the last trading day of the past quarter
Earnings Per Share (EPS*) = ( trailing 4 quarters earnings / outstanding share of common stock )
So if a company stock ended the last quarter at $15 / share, it had trailing 4 quarters earnings of $20 mm, and it has 30 mm shares outstanding, the calculation would look as follows:
P/E Ratio = ( 15 / ( 20,000,000 / 30,000,000 ) )
P/E Ratio = 22.5x
* For more information on EPS, see my geek-out Wednesday note on EPS here: https://www.siebertnet.com/blog/index.php/2018/10/10/step-forward-step-back-repeat/
Now that we know how trailing P/E is calculated let’s get into how it should be used to determine value. In general, companies with a high P/E ratio indicate that a company has high growth prospects as investors are willing to pay a large amount for $1 of earnings. Conversely, companies with low P/E’s are those that may have low growth prospects. Looking at a company’s P/E on its own can provide a high level value view but the P/E becomes a much more effective tool when used in comparison to other companies and indexes. For example, if a company has a P/E of 5x, one might assume that a company is cheap, but if it is compared to another company in the same industry that has a P/E of 2x it may look expensive. That is why it is important to view P/E relative to similar companies or the same sector. Taking it one step further it is important to recognize that there are many other factors that affect a companies P/E. For example, in comparing two similar companies in the same industry group one may have a lower P/E due to its larger debt load, reflecting lower potential growth prospects due to debt burden.
You can see that comparing earnings multiples is a good first step in seeking value but it is important to look further into a company to determine why it may be cheaper than its peers. Taking P/E one step further many analysts prefer to use forward P/E or PEG ratios to get a more accurate read of company value. The forward P/E uses analyst earnings estimates for EPS, thus factoring in future prospects versus backward looking performance. Remember one of the basic Wall Street tenets that past performance is no indicator of future performance. The P/E growth ratio or PEG ratio divides the P/E by a company’s earnings growth, so if a company has high growth causing it to have a low PEG ratio it can be viewed as a valuable investment with good growth prospects. Finally, P/E is often used in general terms (as I did in the opening paragraph) to describe stocks in general. The S&P 500 currently has a weighted average P/E of 17.58x compared to 23.5x , which is where the index started 2018 so it can be said that stocks have become cheaper relative to where they have been in the past. Taking it a step further, if we look back to 1954, the P/E of the S&P500 was as low as 7.5x in 1980 and it got as high as 29.83x in 1999. On average the S&P has had a P/E multiple of around 15x. Now that we have some perspective we can say that stocks are cheap at 17.58 times earnings relative to where they were trading earlier in 2018, however historically speaking they can be said to be fairly valued as the average monthly P/E over the past 10 years has been 17.73x. So like all things in investing, it pays to do your homework and ask lots of questions before jumping to conclusions.
Today, the Federal Reserve will release the minutes from its last Federal Open Market Committee meeting at 2:00 PM Eastern and virtually everyone will be looking it over carefully to see just how broad and deep the discussion was around the “further gradual” rate hikes language that was in the release. Additionally analysts will want to see the discussion around how the trade war and the 4th quarter rout in stocks affected the Fed’s decision. In the interim, prospects for successful trade talks will dominate the markets leaving many wondering if, how, and when the Government shutdown will start to have some real affects on the markets. Please call me if you have any questions.