Thursday, April 10, 2008

Thursday's Psychology

As you know, we opted to focus on earnings rather than economic data this week. Our team analyzed Alcoa Inc (AA) Monday and Bed Bath & Beyond (BBBY) Wednesday. Scroll down to view the analyses.

Conference calls for Genentech, Inc (DNA) and General Electric (GE) are on tap after today’s market close and tomorrow before market open respectively. GE is the most powerful signal of the macro economy and major S&P component and has the potential to cause volatility tomorrow with its earnings report and CC. We will post our analysis within 2 hours of the conclusion of the CC. (Live links for all of these CCs are in the left margin.)

We’ll be listening closely to the psychology of every exchange between analyst and manager. There’s much more to stock valuation than simple P/E ratios and other past performance data. That’s why we updated this article for all of our readers in no fewer than 59 countries to enjoy: Grazie, Danke, Merci, Dziekuje, Bevlakisha, Kahm sa hamnida, Arigatou gozaimasu, Spasiba, Thank You!

S&P 500 Index: Third Grade Math versus High School Economics & Psychology

A fundamental measuring stick of stock market value is the ratio of the price relative to the latest 12 months' earnings, or the Price Earnings ratio (P/E). History shows that in bear markets the S&P 500 P/E ratio can dip below 10. There was one instance, in 1974, where the P/E of the S&P 500 dropped to 8. On the flip side, bull markets can drive the Index P/E to above 25.

The S&P 500 P/E Ratio is calculated by dividing the trailing 12 months' of earnings of the 500 companies by the cash price of the Index. You probably know that a market P/E of 18 or higher is usually considered a sign of overvaluation; and when the P/E dips below 10, the market is historically considered undervalued.
Today's S&P P/E is at 16; the cash Index stands at 1,370 with trailing earnings per share (eps), equivalent to $85.00 for the 500 companies. That’s third grade math, pure and simple.
Here's the full list of companies of the S&P 500: notice the sector concentration, especially the ‘financials’:

Now, the $64,000 question for an investor is: What will earnings be in the next 12 months? $93.00, $76.50, or flat at $85.00? And more importantly, is there a science we can use to predict what that number might be? Successful investing addresses the future, not the past.

In our opinion the latest S&P 500 earnings reflect the weak U.S. dollar. So what are the ramifications of a stronger dollar going forward? One of our Professors once asked to see a show of hands of ‘Accounting’ and ‘Finance’ majors. He drew a horizontal line on the chalk board with a small vertical line dividing it in half. Pointing to the left side of the line he told the Accounting majors that they were students of the past, then pointing to the right side he congratulated the finance majors because, in his words, "they were studying the future, the difficult task of forecasting".

Will future increases in U.S. unemployment lead to lower wages and greater S&P profits? The report today showed a more positive employment picture. ( Keep in mind these numbers are still being pressured from the auto, finance, and housing sectors; one report does not a trend make.

Did the brilliant Scottish economist Adam Smith predict a bull market in 2008 more than two centuries ago? In his masterful 1776 opus Wealth of Nations, Smith believed corporate profits would increase during rising unemployment: As presented on Wikipedia: "Smith argues that the profits of stock are inversely proportional to the wages of labor, because as more money is spent compensating labor, there is less remaining for personal profit. It follows that, in societies where competition among laborers is greatest relative to competition among employers, profits will be much higher."

So does last Friday's April 4th 76,000 increase in the number of unemployed workers, (now above 5.1% on an annual scale), signal a boom for S&P profits going forward? We believe this argument is valid.

Now add the synergies of the weak U.S. dollar and strong foreign currencies to that rising unemployment: neoclassical Adam Smith, perhaps? Are you aware the U.S. dollar printed a fresh low versus the 15 nation Euro today?

A trusted friend at the Goldman Sachs corporate NYC offices feels the U.S. dollar will continue to be weak. He also believes that it's possible that U.S. exports will be competing head to head versus Chinese exports soon. That would be a very bullish scenario for the S&P index in 2008.

We ask our readers to respect the Price to Earnings ratios (P/Es), Price to Sales multiples (P/S), Quarter over Quarter (Q/Q) and Year over Year (Y/Y) Revenue and Earnings Per Share (EPS) growth rates. BUT never forget market mechanics always work in a forward-looking direction, often fooling herd mentality at thematic turns. Which way do you believe the S&P will go in 2008?

On the other hand, if the dollar were to strengthen markedly - say more than 20% versus the Japanese Yen and Euro - and stabilize, then Institutional funds may sell the S&P index and look elsewhere for better value, maybe in biotechnology names like Genentech Inc (DNA), who has a Conference Call scheduled for today.

Or maybe the funds would go to other geographies altogether. Have you ever considered buying American Movil (AMX)? Many breezed through third grade division, while finding high school psychology & economics more challenging.

The Psychology of the Call team wants you to be armed with all sciences at all times, without ever thinking the exact science of math is the Holy Grail to your $ucce$$.

Thank you for your Thursday attention.

No comments: