Price to Earnings Ratio

This post will discuss one of the most used financial ratios-the price to earnings ratio, or P/E ratio.  Benjamin Graham preferred companies that did not have a P/E above 15.  The inverse of the P/E is the anticipated “yield” of a stock, meaning a P/E of 15 represents a 6.7% earnings represented by the current price of the stock.

In a previous attempt to make investing easy, I used P/E lower than 15 as a single and only reason to invest.  This is not a good way to do so, I experienced mixed results at best.  However, P/E is a good starting point on investing.  I agree with Graham’s perspective on P/E and avoid purchasing a stock if it trades at a price higher than a P/E ratio of 15.  This typically causes me to avoid companies like Nvidia (current P/E 55.78) and Google (current P/E of 29) but it did allow me to purchase Apple last year when it traded at 96.42 (P/E of 12.85 at that time).  Since that purchase, the share price has risen to 115.82 as of this writing, not bad for a one year return on investment.

Being Paid to Invest

What if someone paid you to invest in securities you already wanted to own?  This post will cover one strategy that allows the investor to receive payment on investments they want to purchase.

Tom said to himself that it was not such a hollow world, after all. He had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.

-The Adventures of Tom Sawyer, Mark Twain

This is Tom’s light bulb moment for the fence painting episode.  This is the same type of light bulb moment I had when I first learned about cash secured puts.  Such a strategy is not for everyone, please understand that options trading adds an element of risk much greater than the normal stock or mutual fund investor is willing to assume.

What is a Cash Secured Put?

A cash secured put is created when an investor provides an option to sell a security at a fixed price.  The investor is paid for providing this service by the individual that buys the right to sell the security at the strike price (think sale price), this investor assumes the responsibility to purchase it at the strike price if the buyer wants to sell it.  The investor using cash secured puts is selling the put.  The individual purchasing the put is usually trying to lock in a price to sell and pays the seller a fee for tying up the underlying cash required to purchase the security.  Sellers use this strategy to provide income on a regular basis when they wish to keep their cash on hand.  Buyers use this strategy to lock in profits on an investment that has appreciated in value.

How to use Cash Secured Puts 

Selling a cash secured put to be paid to invest should start with an understanding of what price you want to purchase the underlying security.  When you determine such a price, then you sell the put at that price.  If the security falls below the price of the put, then it is considered in the money.  If it stays in the money upon expiration, then the purchase will be “put” to you and you will be required to purchase at the price indicated by the option.  Your purchase price is the stock price discounted by the sale price of the put.

A word of Caution

All option trading can be highly volatile.  Most professionals use options only as a small portion of their portfolios (1-3%).  However, this strategy can lock up a large portion of your portfolio in cash until you close out of the position.  Using this strategy to purchase an option when a company is high that later falls often forces the investor to purchase the stock at a premium to what it current price is causing them to assume the risk of the falling stock.  This makes it an extremely risky strategy to use when purchasing companies that are not investment grade.  I do not recommend using such a strategy to purchase anything but investments with the least risk.  Limiting cash secured put sales to stocks found in the Dow Jones Averages including the Industrial Average, Transport Average, and Utility average would mitigate some of this risk.  

The opportunity

A conservative application of this strategy offers an opportunity to earn approximately 2% annually while preserving cash for specific entry points.  This may not seem like a lot, however, it provides income when the investor thinks the market is overpriced.  It is a great way to make your money continue to earn when the market seems overpriced.  Your efforts are rewarded by a constant stream of cash for the security you offer the investor.

ACTION ITEM: Determine for yourself if you are willing to assume the risk of a stock falling.  Is this the right strategy for you?  If so, what will you do to limit the risk involved?

Stock Market Forecast 12/17/2016

Stock market value determination is fundamental to an investor interested in purchasing portions of the market at a reasonable price.  Forecasting is an important part of any active investment style.

“The cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run.”
― Henry David Thoreau, Walden

The time spent understanding a situation is the ‘life’ Thoreau mentions in the preceding quote.  When considering the cost required to value the market, lets look at ways that capitalize on the amount of time required in exchange.  This post will discuss a little wisdom from Benjamin Graham, some analyst reports one might consider, and some current trends in the news.

A Thought from Ben Graham

Benjamin Graham used the price to earnings (P/E) ratio to identify when a security was over priced or priced at a discount.  A simple way to look at this is to compare the P/E ratio’s current level to that of the security’s average.  When the P/E is lower than the historical average P/E, then Graham proposed that the price of the underlying security is trading at a discount.  Historical data that identifies the monthly average P/E of the S&P 500 to be roughly 15.60 (from data found on www.multpl.com).  This is the average of over 100 years’ of data.  Note that over the past 20 years this average is trending upward.  This indicates that if the S&P 500 drops below a P/E of 15.60, then it is at an appropriate entry price.  The S&P 500’s current P/E ratio of 24.98 (found on wsj.com) would indicate that the average is about 60% overpriced.

Professional Advice

Professional services share their perspective of where they expect the market to be heading.  My personal favorite is the Value Line Investment Survey, but there are others to consider.  Warren Buffet was once quoted stating that he liked the S&P report.  These companies that do this type of work are not all the same so if you are using their information make sure it is from a reputable organization.

Value Line’s weekly report indicates the anticipated price change for the stocks in the Value Line survey will be over the next five years.  The highest expected five year return was 185% during the financial crisis, last week it was 35%.  Value Line uses a proprietary arithmetic formula for its calculation and the investor will have to pay for such advice-or get access to it at a local public library.  Most public libraries will have this in their section on investing.

The S&P Capital IQ Outlook report is another paid service.  This report is free to those with a TDAmeritrade account.  The S&P outlook for 2017 states that the current bull market is the second most expensive market top since WWII with a trailing (meaning the last 12 months) P/E of more than 25x! The Outlook report also points out that the S&P 500 fell an average of 2.7% during the first year of a new Republican president.  The report states that only once did the year following the election of a new Republican president end with a gain.  Finally, S&P predicts that this market will continue to stay ‘aloft’ through the next year.

The Argus Market Watch Report is also free with an account from TDAmeritrade.  This report compiles several different analysts and provides a diary of a 12-month forecast for the S&P 500.  This forecast puts the price of the S&P 500 to be somewhere between 1,800 and 2,250.  The S&P 500 is currently trading just over the high end of this range.  Argus does not appear to have updated this range since December 2015, making any confidence in this prediction low and leading the reader to question how current it is.

These agencies can be wrong they provide predictions because their customers ask for it.  In fact there exists a strong argument to anyone wanting to lay some blame of the financial crisis at various rating agency’s feet.  They also use words that try to make their predictions less clear like the S&P report use of the word aloft.  However, they do give a good idea of the sentiment that is current in the market and most of their customers want to see the logic behind such predictions.

Current News

Stories in the news talk of the way people are piling in on the purported “Trump trade”.  The “Trump trade” is the price jump that occurred in the US stock market after the election.  This price jump was sharp and had very few losses over the past few weeks.  This indicates that the index may be overpriced.

Assessment

My experience with P/E ratios, professional advice, and news articles teaches me that this data needs confirmatory evidence.  The evidence I considered for this post causes me to conclude that the stock market is currently trading at a premium.  This post ends with my personal assessment of the S&P 500 price expectation in the next six months.  Confidence level: MODERATE, I assess that the S&P 500 has a 70% chance of retreating at least 10% (or to $2,033.07) at some time in the next six to twelve months.  Note: this assessment is my attempt to identify market prices over the given period, I use this type of conclusion for my own investing. Before you commit funds to any investment or trade, I encourage you to do your own analysis of the investment vehicles you are looking at.

ACTION ITEM: What price changes do you think will happen in the stock market over the next six months to a year?

Investment Plans, Part 3: ETF Example

“Now, what should happen when you make a mistake is this: You take your knocks, you learn your lessons, and then you move on. That’s the healthiest way to deal with a problem… You know, by the time you reach my age, you’ve made plenty of mistakes. And if you’ve lived your life properly — so, you learn. You put things in perspective. You pull your energies together. You change. You go forward”

– Ronald Reagan regarding the Iran-Contra Scandal

This quote begins this week’s post because it is how I felt about the results of my analysis of a stock investment strategy.  I hope you find the following data useful.  This is a result of over 2,000 data points and my submission of the

This graph shows how an investor would apply their capital over the past ten years in IJH, a mid-cap ETF.  The green represents the weekly closing price of the ETF.  The blue indicates the monthly shares purchased from the ETF under the Dollar Cost Averaging (DCA) method.  Finally, the yellow represents the number of shares purchased under the Price/Volume method (PV) discussed last week.

The inputs into this model are as follows:

  1. The DCA method invested a set amount the first Monday of each month over the ten years.
  2. The DCA method invested the full amount of the investment funds, this is a bit unrealistic because an ETF would require the purchase of at least one full share.  However, this was used to develop the chart because many investors use the DCA method in their personal investment accounts and their investment accounts with their employers.  The reader should note that many employers deposit their investment funds into a holding account until a set date and then apply it into their preferred investments.
  3. The DCA method determined the amount of money to be used by the PV method.
  4. The PV method invested 2.55% of the total investment balance each time the market dropped on high volume and the next week’s share prices included a 2.5% discount to the previous week’s close.  This allows the investor to place an order at the conclusion of the past week at a discount and only purchase if the market drops to that price level.
  5. A buy and hold method was used as a base line investment style.

Key assumptions that may change future application of these methods:

  1. During these ten years, the market had the financial crisis associated with the housing bubble.
  2. This market drop was significant and occurred in the first half of the investment application period.
  3. The investor would require financial stability in order keep the money invested in any of the methods.

Results of these methods are as follows off of a $100,000 investment:

  1. The DCA method purchased a total of 1063.608 shares and the ending value of the investment not including dividends was a respectable $174,570.01.
  2. The PV method purchased a total of 1,392 shares and the ending value of the investment not including dividends was an amazing $225,888.18!
  3. Placing the entire $100,000 into the ETF at the beginning of the ten years purchased 1,226 shares and the ending price not including dividends was $201,223.38.

Conclusions:

  1. Technical investing can add value to your portfolio.
  2. This metric does not seem to be as successful for investment amounts smaller than roughly $20,000.  This is probably due to the economy of scale involved with the larger investment values.
  3. The PV outperformed the tried and true and widely accepted DCA by a gain of more than 58%.
  4. A complete application of investment funds doubled the investment over a ten year period.

The most surprising of these conclusions for me was the first.  I have spent most of my life thinking that technical investing is like reading tea leaves.  This was a very surprising result to me and makes me want to question some of my other mindsets with respect to investing.

ACTION ITEM: Determine what will be the best investment plan for you-DCA, PV or buy and hold.

 

Investment Plans, Part 2

Investment plans can benefit from being quite simple. In last week’s post, we discussed the simple no-hands approach called dollar cost averaging.  This is a great way to get average results.

Average people take average actions.  Average actions bring average results. – Average is an Addiction, Deborah Dubree, Chapter 6

This post will discuss a possible way to get better than average results.  Business schools teach that the best way to make money in the stock market is to buy low and sell high.  Then the business students that go on to tell the world that the best way to make money in the stock market is to dollar cost average.  I think that this is good advice but lacks the thought process to make great advice.  This post will include my opinion of what might be considered as great advice.

Exchange Traded Funds vs Regular Index Funds

In the last post, if you took the second action item, you would have looked at the ETF IVV and the Index Fund SVSPX.  The table below shows some of the performance and other distinguishing data of the two funds.  Consider that IVV and SVSPX returned approximately the same amount over the past five years.  They also had the exact same top 10 holdings at the time of this writing.  The key differences one should consider is the investment amount required and the ability to use options.

Fund SVSPX IVV
Description SSgA S&P 500 Index Fund N Class iShares Core S&P 500 ETF
Category Large Blend Large Blend
Expense Ratio 0.16% 0.04%
Sales Load with TDAmeritrade Account No Load No Load, commission free trading available
Fund Type Regular Index Index ETF
Average Asset Market Capitalization 76.8B 77.2B
Costs over 5 years 0.56% 0.39%
Minimum investment (Initial/Additional) 10000/100 NA/NA
Options available? No Yes
Market return (2012) 16.03% 16.06%
Market return (2013) 32.14% 32.30%
Market return (2014) 13.50% 13.56%
Market return (2015) 1.27% 1.30%
Market return (2016) YTD as of 12/3/2016 5.73% 5.91%

How can an individual capitalize on these index funds?

Thankfully, the business schools out there were very helpful-they said to buy low!  Here is a simple way to purchase shares of a regular index fund at a low price, it is not full proof but over time should improve one’s return.  It seems to work best with an ETF because the investor can purchase at a set amount shares based on what they want to risk like the dollar cost averaging technique, but it could work with a regular mutual fund as long as you can meet the minimum requirements.

Plan 2: Price Change with High Volume ETF investing.

Criteria:

  1. When the weekly price of the Index ETF declines.
  2. The volume of the Index ETF for the week exceeds its 50 day moving average.
  3. Purchase Index ETF shares the next week at a 2.5% discount from the closing price of the mutual fund after that week of high volume decline.
  4. Only purchase at a set percentage of cash available for investing, like the equivalent of 1-3 month’s investment account contribution or 2-5% of a windfall over several months.

Purchasing in this manner will improve the chances of buying low like the business schools out there love to advertise but seem to give little direction on how to do this.  You should note that this method will mean that you invest during some of the scariest times of the market.  It would have placed a purchase during the market downturn associated with the housing bubble in two consecutive weeks at least twice for an ETF I tested it on.  This means that the investor would be purchasing shares during some of the most volatile parts of that crisis and they would have to be disciplined enough to purchase a second time when the market fell the subsequent week after considerable losses the week before.  Most investors would consider this a gut wrenching probability; however, it seems to outperform the dollar cost average approach by a significant margin.

ACTION ITEM: This week’s action item is for you to test this hypothesis on your own and find mistakes in it.  I would love to hear if you find this method working or if you find it not working.  Pick an index fund and determine how this method stands up over time in your opinion.