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Elliott Gue knows energy. Since earning his bachelor’s and master’s degrees from the University of London, Elliott has dedicated himself to learning the ins and outs of this dynamic sector, scouring trade magazines, attending industry conferences, touring facilities and meeting with management... More
My company:
Energy and Income Advisor
My blog:
Capitalist Times
My book:
The Rise of the State: Profitable Investing and Geopolitics in the 21st Century
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  • There's No Magic Number

    In my first year studying economics at the University of London, I took a class on financial accounting.

    I’ll never forget my lecturer; he was an older British man who had been an accountant for around 40 years and did a little bit of lecturing in his spare time. Professors like that were always my favorites because they were the ones who could really give you color on how the world worked in practice rather than how academics feel it should work. He was always quick with an anecdote from personal experience to illustrate every point he made.

    In addition, while British and American terminology for accounting is almost identical, there are some subtle differences such as the fact that the Brits tend to use the term “gearing” rather than “leverage” and the term “profit” rather than “earnings.” Of course, international and US accounting standards also differ in some important ways.

    After he discovered I hailed from “the Colonies” he made a point of addressing me directly during lecture to let me know of these subtle differences. The downside of that was that I could never really get away with sitting in the back of the lecture hall reading the FT. I reserved that practice for my course on European Union business law, where my Italian friend kindly provided me with her outstanding and impeccably neat lecture notes.

    As you might imagine, in my financial accounting class we studied financial statements and learned how to calculate and interpret several dozen financial ratios. One of the first ratios every investor learns to calculate and interpret is the price-to-earnings (P/E) ratio, the ratio of a stock’s price to its earnings per share. I’ll never fully understand why, but the P/E ratio seems to have some sort of intoxicating allure for investors and economics students alike.

    Perhaps it’s the ratio’s ubiquity; the P/E ratio is listed in most stock tables and is among the first bits of information you’ll encounter when looking up a stock on a popular financial website such as Yahoo! Finance or Google. Investing is part art, part science, but many people find numbers to be a crutch they can depend on. The P/E ratio represents a common and well-understood yardstick an investor can digest and quickly interpret.

    But one of the most important lessons I learned from my accounting instructor years ago was that the investment valuation process involves a lot more than calculating a bunch of ratios and putting them into some sort of a grand formula to understand a stock’s true value. The P/E ratio is popular, common and easily understood; unfortunately, many investors either over-rely on P/E ratios in their decision-making process or entirely misinterpret the ratio. The P/E ratio is a tool--one of many in the analyst’s toolbox--but it is not a perfect measure.

    One common fallacy is that a low P/E ratio is good and a high P/E ratio is bad. I’ve been asked on countless occasions why I recommend a stock with a “high” P/E. There are a couple of problems with this question that make it impossible to answer. First, we must understand what we’re actually talking about when we quote a particular P/E; chances are we’re not even looking at the same number.

    Some investors look up a stock on the web and see the trailing P/E, a ratio based on the prior 12 months’ worth of earnings history for a stock. The trailing P/E can be useful, but it’s limited because it’s based on historical data; for example, many stocks had sky-high trailing P/Es in mid-2009 because corporate earnings were, by and large, depressed in the four quarters from mid-2008 through mid-2009.  But valuing a stock based on the worst four-quarter stretch for corporate profits in decades doesn’t make much sense.

    Meanwhile, other investors might be looking at the forward P/E. This ratio is calculated based on analysts’ consensus estimates for a company’s future performance. This ratio can make more sense than the trailing P/E because it’s based on the future, not the past. But it’s also limited by the simple fact that forward P/Es are based on estimates and forecasts, which can be dramatically incorrect.

    Furthermore, analysts have a sort of herd instinct; when one analyst hikes their estimates, you’ll tend to see others also hike their estimates as well. This often leads to a situation where all of the analysts find an overly bullish consensus near the top of the cycle and are overly bearish near the lows.

    And whatever your definition of “P/E,” a high ratio doesn’t necessarily mean that a stock is overvalued and ready to plunge. Check out the chart below of the P/E ratio for oil services giant Schlumberger (NYSE: SLB) going back to 2000.

    Source: Bloomberg

    From 2000 through late 2002 and into early 2003, Schlumberger’s stock fell amid a broader market selloff. As the chart above indicates, Schlumberger’s stock also began to fall over this time period from close to 100 times earnings down to as low as 30 times earnings by late 2001.

    But look at Schlumberger’s P/E in late 2003 and early 2004: The stock had a trailing P/E at that time close to 45. If we exclude the immediate post-bubble high, this would have been considered a rich valuation for the stock. But if you sold Schlumberger in late 2003 or early 2004, you’d have been sorry because the stock rallied from $25 in late 2003 to over $100 by late 2007.

    Similarly, the stock topped out in 2007-08 just as the P/E was touching its decade low. If you think about it, this all makes mathematical sense in that companies in cyclical industries will always have depressed earnings and, therefore, high P/Es near the bottom of the cycle. That’s exactly when you want to buy these stocks; high P/E ratios are actually consistent with buying opportunities and low valuations in cyclical industries.

    Of course, this is based on historic P/Es. But consensus expectations for a stock like Schlumberger tend to be fairly depressed near cycle lows as well, inflating consensus estimated P/Es. For example, consider that in July of 2008, Schlumberger’s P/E based on 2009 earnings estimates was actually lower than it was in mid-March 2006.

    But in the six months that followed Jul. 15, 2008, the stock fell 58 percent and in the six months after Mar. 15, 2009, the stock soared 53 percent. My point is simple: Understanding whether a stock is cheap or dear requires that the analyst make some sort of evaluation as to where we are in the cycle, in other words, whether fundamentals are improving or still deteriorating. You can’t make that determination by solely looking at P/E or any other ratio.

    P/Es can be valuable when evaluated alongside other data but are useless and meaningless in a vacuum. In an upcoming issue I’ll take a look at insider-trading statistics, another indicator I’m often asked about that is egregiously misinterpreted.



    Disclosure: "No Positions"
    Mar 16 10:23 AM | Link | Comment!
  • Downfall of the Cotton King

    Every year there are hundreds of new books released about investing or trading stocks. But only a precious few become enduring classics.

    True knowledge is timeless. Published nearly 90 years ago, Reminiscences of a Stock Operator, by Edwin Lefevre, has stood the test of time and qualifies as a must-read for all who are interested in the stock market. I admit a personal affinity for Lefevre’s work; it was one of the first investing books I read and helped instill in me a lifelong passion for the financial markets.

    Reminiscences recounts the experiences of a fictional trader named Larry Livingstone but is really a thinly-veiled biography of Jesse Lauriston Livermore, a legendary trader from the early 20th century. While Reminiscences was first published in 1923, Livermore is probably best known for making millions in the stock market crash of 1929--and back then being a millionaire meant a good deal more than it does today.

    Livermore was also famous for going broke; he made and lost several fortunes during his career, though he always made good on his debts. Some of the most interesting passages in Reminiscences are those concerning Livermore’s mistakes. It’s truly amazing to watch modern investors lose money making the very same errors Livermore made almost a century earlier. Human nature never changes.

    One of Livermore’s most costly trading mistakes involved a man named Percy Thomas, who was known as the “Cotton King” to his contemporaries. Thomas had a reputation as a well-informed and successful speculator in the cotton markets and attracted a considerable following in both the US and Europe.

    Livermore befriended Thomas and, inevitably, their conversations turned to cotton. At the time Livermore was short cotton (betting on a fall), while Percy Thomas was a cotton bull. Livermore admits that when he started talking to Thomas he couldn’t see the bull case for cotton at all, but Thomas brought up so many facts and figures in support of his opinion that Livermore ultimately relented, becoming convinced he was wrong and Thomas was right.

    As Livermore  states in Reminiscences: “A man cannot be convinced against his own convictions, but he can be talked into a state of uncertainty and indecision, which is even worse , for it means that he cannot trade with confidence and comfort.”

    Livermore not only covered his shorts and bought cotton. But he continued to buy cotton even as the trade soured, and he began to lose money. In what Livermore calls the most asinine move of his career, he actually took profits in wheat and other markets to maintain his money-losing cotton position. Ultimately, Livermore was nearly ruined by that single trade.

    Livermore was talked out of his convictions in cotton because of information presented to him by a man he describes as brilliant and a “magnetic” personality. The lengthy series of facts and inside information that Thomas presented to Livermore cost him dearly.

    Although it isn’t explicitly written in Reminiscences, Thomas likely wasn’t intentionally misleading Livermore. It’s likely he truly believed in the strength of his analysis and the quality of his contacts in the cotton-growing region of the Southern US. Thomas was falling prey to a classic mistake: fighting the tape by ignoring market action and the fundamental bearish news surrounding cotton markets.

    Human beings have an almost limitless capacity to look at a large amount of data and find some patterns to support their pre-conceived notions. I have no doubt Percy Thomas was predisposed to be bullish cotton and found plenty of information he could use to back up his view.

    Just as Livermore was blinded by Thomas’ eloquent analysis and talked into a state of uncertainty, it’s all too easy for modern investors to be led astray by the seemingly endless data releases and market commentary available these days. The information overload leads to paralysis as investors stubbornly cling to a particular view even when a dispassionate read of the market and fundamental data points in another direction.

    It’s human nature to identify oneself as a market “bull” or a “bear,” and these classifications are perennially reinforced in the popular media. However, as Livermore once said, “[T]here’s no bull side and no bear side, only the right side.” Just as it was hard for Percy Thomas to shed his Cotton bull predilections it’s hard for most investors to divorce themselves of long-held beliefs when conditions change.

    In some professions perseverance and downright stubbornness are positive attributes. But that’s not the case with investing. Flexibility and a willingness to alter your view are absolutely necessary.

    The Bear’s Den

    Following conversations with scores of investors at the Orlando MoneyShow earlier this month, it became clear that most are at heart negative on the US stock market and economy. Since the 2009 Orlando conference, global equity markets have enjoyed one of the most powerful rallies in history, but that move has done little to dispel bearish sentiment.

    As longtime readers know, I have considerable sympathy for this view. Over the past six months I’ve discussed at length the longer-term headwinds the US and many other developed countries face in coming years.

    Some investors asked if my near-term bullish stance reflected a belief that the stimulus package passed roughly a year ago is working. The answer to that question is an emphatic no. Although I’m certainly aware that if you throw enough money at something it will probably go up in price, I firmly believe the longer-term damage caused by excessive government spending far outweighs any near-term benefit.

    I continue to believe that the experience of the United Kingdom in the 1960’s and ’70s remains relevant to the US today.

    But we can’t make money by doggedly and stubbornly sticking to the bearish case when market realities and the data point in another direction. It’s certainly possible to sift through the dozens of economic releases released in the US and overseas each week to find some data to suggest the economy is destined for a double dip this year and that the market is ready to make a major move to the downside.

    Jesse Livermore lost most of his fortune by ignoring his own convictions and the market to listen to the Cotton King. And Percy Thomas convinced himself he was right to be bullish by seeking out data to support that view. Both men were nearly ruined by the experience.

    Emotions have no place in the market, and to make money it’s important to analyze the market and economy dispassionately. One of the best ways I know to control emotions is to   identify a toolbox of data points and indicators that you follow consistently; if your market positioning isn’t in line with those indicators you should seriously re-examine your rationale; you may well be making the same mistake Thomas and Livermore did nearly a century ago.

    The Conference Board’s Leading Economic Index (NYSEMKT:LEI) is one indicator I follow closely.

    Paying attention to the signals the LEI gives helped me to call for a recession in January 2008 in The Energy Strategist, when many pundits were still predicting the US would skirt recession. The LEI also told me that conditions were beginning to improve last spring and convinced me it was time to more aggressively play the bull side.

    I’ve analyzed the patterns in this indicator over several decades, and it’s not perfect. But the LEI offers good, consistent signals and shouldn’t be ignored.

    Source: Bloomberg

    This chart shows data on two indexes, the LEI and US year-over-year change in gross domestic product (NYSE:GDP). The LEI is released monthly, but I used quarterly data to make it comparable to GDP. Please note that the current year-over-year change in GDP is around 0.1 percent; the more commonly quoted 5.7 percent figure for the fourth quarter is  simply the fourth-quarter growth rate on an annualized basis. I’ve presented data back to the mid ’60s.

    Although the correlation isn’t exact, it’s clear that turns in the LEI have typically done a good job of calling turns in economic growth a few months into the future. It’s not hard to see that the purple line on my chart (the LEI) has a tendency to bottom a quarter or two before economic growth also hits a nadir.

    Similarly, note how sharp declines in the LEI data often presage a significant slowdown in GDP a few quarters in advance.

    Plenty of pundits would argue that the LEI isn’t relevant in this cycle because this one is different than past experiences. I agree that there are differences with this cycle, but it’s tough to dispassionately look at a chart like this without recognizing the relevance of the LEI as an indicator.

    And the indicator seemed to work equally well during the high-unemployment environment of the ’70s; “this time is different” is the most expensive phrase in finance, and I wouldn’t be so quick to ignore the LEI. My basic premise is that the secular trend for the US economy has taken a turn for the worse, but this doesn’t mean the business cycle is irrelevant. The LEI signals a continuing cyclical recovery for the US in 2010, not a double-dip recession.

    Note that the latest LEI data, released for January, isn’t pictured on this chart because I’m using quarterly data. But the LEI jumped another 0.3 percent for the month, slightly below the consensus forecast. However, the Conference Board also revised upward the prior month’s data. All told, the latest reading on LEI continues to point to recovery.

    And for those who still consider the LEI to be imperfect, the Conference Board also releases two additional indicators as part of the same monthly release, the Coincident Economic Index (CEI) and the Lagging Economic Index (NYSEARCA:LAG). The CEI is designed to reflect changes in economic conditions as they happen, while the LAG tends to act as a confirming indicator, making turns months after the broader economy.

    Here’s a chart of CEI and GDP depicted on the same basis as LEI and GDP above.

    Source: Bloomberg

    This chart is actually a bit harder to read than the LEI-GDP chart because the lines often so closely overlap. It’s fair to say that the CEI and GDP tend to follow very similar patterns. As you can see, the CEI began has begun to turn again this cycle at exactly the same time GDP bottomed out.

    The CEI was up another 0.2 percent in January, with three out of the four constituent indicators advancing. Out of the past seven months the CEI has increased in four months and has remained flat in the remaining three. Like the LEI, the CEI points to a recovery.

    Many investors argue with LEI signals because several of the constituent indicators-- including money supply and interest-rate spreads--are heavily influenced by the government.

    The CEI at least partly addressed this concern; it has only four constituent indicators, and none are as directly under the government’s control. Here are the indicators in the CEI, in order of importance: employees on nonagricultural payrolls; personal income less transfer payments; industrial production and manufacturing; and trade sales. Note that even the personal income indicator nets out government transfer payments.

    The LEI and the CEI tell me that, long-term structural concerns aside, the US economy is enjoying a cyclical recovery. And that spells more upside for stocks this year.

    Stocks on the Run

    I’ve been speaking at investment conferences and for smaller investment groups for more than seven years. By far the most common question I’m asked is “What’s your top stock pick right now?”

    Investors always want to come away from each workshop with at least one or two high-quality investment ideas; for me the problem has always been narrowing down my favorites to just one or two names.

    Every week, I have a working lunch with my colleague Yiannis Mostrous, editor of The Silk Road Investor. As you might imagine, the conversation inevitably turns to the market and our favorite stocks and investment ideas. These lunches have evolved into a sort of friendly competition over who comes up with the best ideas; the competition and need to defend my views has certainly inspired me to flush out some profitable investment ideas over time.

    Last October I was at Yiannis’ home for a late-season barbeque. Over a glass of wine and the remnants of a rib eye we came up with a simple concept: Why not offer the ideas we come up with in our weekly meetings to our broader subscriber base?

    Even better, why not address investors’ desire for a straightforward, clear investment idea--a top stock pick--each month by leveraging the fruits of our conversations and debates?

    That’s the idea behind our brand new advisory, Stocks on the Run. Each issue, on the first Monday of the month, contains a single stock recommendation vetted by both of us along with the basic rationale for buying. The service is designed to be simple and straightforward -- no lengthy economic analysis, no extraneous commentary about the broader market, just a simple, profitable stock to buy now.

    The service won’t leave you hanging. Each monthly e-mail will contain advice on what to do with prior recommendations, and we’ll send out alerts as needed to update recommendations between issues.

    Our February pick--a play on agriculture--is already on the move, and we’ve identified a short list of candidates for the March play. We’re meeting next week to make the final decision on our next pick.

    We wanted to make this service affordable, so Stocks on the Run costs just $5 per month, a nominal fee to defray the costs associated with running the service. You can cancel at any time.

    Interested in finding our more about Stocks on the Run? Click here.

    If you sign up today you'll receive our February pick immediately. Our next Stock on the Run will be released Tuesday, March 2.

    Race to the Summit

    A panel discussion on the state of the economy. Presentations by each of our expert editors. One-on-one time with those experts. A sunset cruise of San Diego Bay…

    April 23-24 could be your most important weekend of the year. Roger Conrad, GS Early, Yiannis Mostrous, Benjamin Shepherd and I will reveal the brightest trends and our best recommendations--and anything else you might want to know--during the 2010 Wealth Society Member Summit at the historic Hotel del Coronado.

    They say it’s 72 and sunny every day of the year in San Diego, and in late April it probably will be. Tranquility and relaxation is good; that and the best independent view of global investing make a great combination. You may find all details at www.InvestingSummit.com.

    Call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table. Space is limited.



    Elliott Gue is Editor of Personal Finance, The Energy Strategist, and Co-Editor of MLP Profits.



    Disclosure: "No Positions"
    Tags: Cotton, Markets, LEI, GDP
    Feb 23 10:35 AM | Link | 1 Comment
  • Revenues on the Upswing

    Investors should always keep a careful eye trained on US and global economic conditions. But the fundamentals that ultimately move stocks are corporate profits and sales.

    One of the most persistent bearish arguments against equities in recent quarters has been that although companies have been able to beat earnings expectations, most of that upside was driven by cost-cutting. Of course, one of the most common ways companies cut costs is to lay off workers when demand slumps; the surge in the US unemployment rate over the past two years is a sure sign firms are doing just that.

    By cutting labor costs firms have boosted profit growth even though demand has remained weak. This technique is only useful to a point. Early in a downturn it’s relatively easy to trim fat, but at some point it becomes hard to make additional cuts without effecting long-term competitiveness. Cost-cutting frequently drives a recovery in corporate profits early in a cyclical upturn, but ultimately it’s unsustainable--firms need to see actual growth in demand to drive earnings.

    The most common proof of this case: Although companies have beaten profit expectations, revenue growth has remained weak. Sales growth offers a better picture of actual end-market demand than earnings, and sales are far harder to “manage” with accounting tricks and obfuscations.

    But this bear case is crumbling. Check out the table below, which details earnings and revenue results released so far this season.

    Source: Bloomberg

    Nearly three-quarters of the companies represented in the S&P 500 have reported fourth-quarter results as of February 12. Of that total, 75.7 percent have beaten consensus analyst earnings estimates heading into the quarter. Average earnings growth is close to 47 percent, an impressive figure in any historical context.

    However, what’s really different this quarter is that most stocks are also beating sales estimates. Close to 70 percent of S&P 500 stocks have beaten on the top line, and the average revenue growth rate for the quarter is 7.4 percent.

    Also note that I’ve broken out results for each of the 10 official S&P economic sectors. Strength on both the revenue and earnings lines is broad-based, with almost all sectors showing better-than-expected growth. Only three economic sectors have posted negative earnings growth this quarter, and just two are still seeing shrinking revenues.

    Particularly notable this quarter is the strong showing from the Information Technology and Health Care industries. Outside of financials, these two groups are showing the strongest revenue growth rates. And in both cases well over 80 percent of reporting firms have beaten expectations.

    Commentary and guidance from IT firms was particularly upbeat. This is reflected in the fact that analysts have been steadily boosting earnings and sales estimates for 2010 and 2011 as earnings season has progressed. For the S&P 500 Information Technology Index, analysts’ earnings estimates for 2010 are up 5.5 percent over the past four weeks alone, and sales estimates are up 3.4 percent. Also helping IT is that the sector has significant leverage to markets outside the US, where demand has been quicker to bounce back.

    Remarks by the largest technology firms suggest enterprise spending is snapping back this year. Businesses cut back on buying new IT products during the 2007-09 downturn in an effort to cut costs.

    These firms have under-spent on technology upgrades in areas as wide-ranging as software, PCs, networking equipment and IT security. Companies will now need to play catch up to keep their systems up to date and to keep pace with the projected growth in Internet traffic in coming years--the amount of data traveling across the Internet is projected to roughly quadruple between 2009 and 2013.

    Another factor driving technology spending is the release of Microsoft’s (NSDQ: MSFT) Windows 7 operating system (OS). Microsoft’s Vista, released globally in early 2007, was widely panned, and many corporate buyers simply stuck with the company’s older XP software.

    But Windows 7 has received better reviews, and the early adoption rate for the new OS is far faster than for Vista. In its recent quarterly conference call Microsoft noted that by the end of 2009 it had already sold 60 million Windows 7 licenses, making it the fastest-growing operating system in history. Microsoft also plans the release of its new Office suite of word processing, presentation and spreadsheet software later this year.

    The release of new Windows operating systems is often a catalyst for companies to upgrade their equipment. Because companies opted not to upgrade to Vista, there’s even more pent-up demand than in most cycles.

    Another firm to watch as a gauge of enterprise IT spending is Cisco Systems (NSDQ: CSCO), a market leader in networking products such as routers and switches. And, thanks to a spate of acquisitions over the past year, Cisco has also entered a variety of new markets, including network security, software and services.

    Cisco management was upbeat during its recent conference call. The company beat expectations for the most recent quarter and guided analyst expectations for 2010 revenue and earnings sharply higher. Management also noted it was seeing broad-based strength across its product lines and all geographic areas; because enterprise customers are Cisco’s bread-and-butter, this suggests that IT budgets are loosening.

    Amid the positive backdrop of better-than-expected earnings reports and the return of actual revenue growth, investors are likely wondering why the market has endured a correction of roughly 10 percent from January highs to recent lows. And though the IT sector is showing some of the strongest fundamental performance of all, it remains among the worst-performing groups in the S&P so far this year.

    The rally in the broader market averages late last year reflected growing expectations for stronger corporate profits in the fourth quarter. Although companies are beating published consensus estimates, some of these better-than-expected results were likely already priced into shares. Technology stocks were among the best performers in 2009, so it’s only natural that they’d now be seeing a more severe correction than your average S&P 500 stock this year.

    More broadly, I continue to believe the US market is in the midst of a classic growth scare. Economic data rarely uniformly points in the same direction, and recoveries never proceed at a steady, uninterrupted pace. Weaker-than-expected US and EU economic data early in 2010 coupled with fears of a Chinese slowdown prompted by government tightening have raised fears that the global economic recovery is stalling.

    We’ve seen this before. Last summer a spate of weaker economic data prompted a correction in the S&P 500. And back in 2004 the market was range-bound for much of the year over fears the US economic recovery was faltering. The fact that investors are looking to take profits after a big run-up just adds fuel to the pullback.

    My take remains that investors are largely too pessimistic about the next 12 to 18 months. There’s no sign yet of concerted weakness in US economic data, and the US Leading Economic Index (NYSEMKT:LEI), one of my favorite quick measures of US economic health, continues to point to a strengthening recovery. Furthermore, the data from individual companies in a wide variety of sectors remains positive as I outlined above.

    As my colleague Yiannis Mostrous points out, investors’ fears of a major economic slowdown in key emerging markets such as China and India are overblown.

    Corrections of 10 to 15 percent for the S&P 500 are common in the context of a broader market rally. This means there could be some additional downside for the averages short term. But I see this as a buying opportunity, not reason to sell.




    Disclosure: "No Positions"
    Feb 16 11:52 AM | Link | Comment!
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