Weekend Strategy Review 7/16/16

Posted by OMS  at July 16th, 2016

The markets closed the week on a mixed note.  The Dow rose 10 points on Friday, closing at 18.517   It was up 370 points for the week. The SPX was down 2 points on Friday and up 32 points for the week. The NASDAQ was down 4 points on Friday and up 73 points for the week   The Dow Utilities were down 7 points for the week.

The Dow Industrials and SPX have made new historical highs, but the NASDAQ and Dow transportation index have not.  And while the Dow was up big for the week, the Dow Utility index was down. 

I heard a lot of talk from commentators during the week about foreign money chasing yields.  On the surface, it would appear that this argument was correct because the higher yielding stocks tend to be in the large cap indexes like the Dow and SPX.  NASADAQ stocks tend to pay little or no dividends, while utilities tend to be among the highest payers.  But during the week, the Dow and SPX were up pretty big, but the Utilities were down.  You would think that if money was really chasing yields, the Utilities would be the stocks that would be up big. Hmmm?  But let’s look deeper.

A year ago, the Dow Utilities had a P/E ratio of 16.71.  Today the Utes are priced at a whopping 24.54 times earnings.  So clearly the Utes are not cheap.  A year ago the Dow Industrials were priced at 16.68 times earnings.  Now they’re three points higher at 19.68.  The average dividend yield on the Dow is 2.50 vs. 3.09 for the Utilities.  So if you buy the Industrials, you can get a slightly lower yield for a lot less in terms of P/E.  Maybe that’s why the Dow was still attracting money this week while the Utes started to pull back.

But yields are not the reason most investors buy stocks, especially when the average yield (dividend) is only 2.5 percent.  So I’m not ready to buy an argument that investors are chasing yield.  Besides, buying yield when equity prices are at historical highs is a very risky proposition.

Ordinarily, I don’t pay too much attention to P/E ratios when I trade.  But I do check them to make sure I’m not paying an insane price. 

For example, if I’m going to take a small position in a company, I always look at the purchase as if I were buying the entire company.  Here’s my thought process:

To make things easy, let’s say that I’m thinking about buying shares of a company that had earnings of a dollar with a P/E of 8.  So if I assumed that there was only one share of the company, and paid $8 for the share, I would receive all of the $1 earnings from the company.   And if nothing changed, in eight years I would have gotten back all of the money I used to purchase the company, and continue to collect the $1 in earnings. 

On the other hand, if I bought a tech company like Netflix (NFIX) with a P/E of 339, and collected all of the earnings, it would take me 339 years before I got all of my money back.  This is something that students should realize when they buy companies like NFLX, TWTR or YHOO.  These high P/E companies tend to get hyped in a good market.  But when times start to get tough, they are the ones that come crashing down.

This is why I always check the P/E before I consider buying a stock.  In this market with the S&P500 supporting a P/E of 24.98, stocks are not cheap.  And if investors are putting money into this market at these high P/E ratios just to get yield, it’s not only a risky strategy, I believe it’s insane. 

But when European investors have to pay banks to hold their money (negative interest rates), which is a guaranteed loss, even a risky strategy of buying stocks with an average P/Es near 25 might appear to be reasonable.  I don’t think it’s reasonable at all. I think it’s bizarre!

The patterns suggest the markets are getting very close to a major top.  During the week, we saw the Dow almost complete wave ‘c’ of a Hockey Stick pattern that projects a target of 18,600. It got as high as 18.557.  So one more small rally early next week should complete the pattern.  If this pattern marks the top, there will be a lot of people holding a lot of very expensive stock.  Equities will have moved from the hands of the smart money into the hands of the less informed.  In a few weeks, these same people will be wondering why they paid so much to get a yield of 2.5 percent. It’s what happens at market tops.

With patterns that appear to be nearing completion, I’m just waiting for the indicators to turn negative.

BTW, Netflix reports its earnings on Monday after the close.  The consensus estimate is 0.02.  The results for the same quarter last year was 0.06, so the year over year estimates have been reduced significantly.  With a P/E in the stratosphere, investors better hope that NFLX will come in close to the consensus estimate. Otherwise they could see a significant drop in the price of the stock from its current lofty levels. And If NFLX starts to pull back, look for other high P/E stocks to experience selling pressure.

Have a great weekend.

That’s what I’m doing,

h

Market Signals for

07-18-2016

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