Archive for May, 2015

What Is The Market Saying?

Thursday, May 28th, 2015

sp-500-pmo

Click on any chart for a full size version

I thought we ought to take the temperature of the market and see what it is trying to tell us about the status of the current bull run. To do that, I have included four long-term trend charts that I have watched over the years that help me know when to get conservative with client money and when to get aggressive. Let’s see what they say.

Above is a 20-year chart of the monthly S&P 500 with the Price Momentum Oscillator (PMO) at the bottom. You can see that I have circled various points in time where the blue PMO line has crossed over its red indicator line. A cross to the downside indicates the market is weakening and a cross to the upside indicates the market is strengthening

The change in the PMO generally coincides with a change in trend for the stock market (see the circles in the index where it crosses below its long-term moving average). As prices begin to weaken and investors’ buying enthusiasm wanes, the PMO captures that before prices fall enough to do too much damage to a portfolio. The really important thing to note here is on the magnification of the chart at the far right. You can see that the PMO has had a negative cross-over – IF history provides any indication as to patterns within the stock market, the stock market should weaken and turn down soon.

Notice I said IF because chart watching is an art and not a science.

trix-divergence

This chart is another one that concerns me. It is a daily chart of the S&P 500 compared to the TRIX Indicator. The TRIX is a momentum-only indicator and tells us when the market is starting to weaken. You can see I’ve drawn boxes around times when the TRIX is pointing to a change in market direction and I’ve drawn circles around the market’s divergence with the indicator UNTIL it changes direction. The important thing to see here is on the far right side of the chart – there is a negative divergence where the TRIX has turned negative but the market continues to move higher. IF history provides any indication as to patterns within the stock market, the stock market should weaken and turn down soon.

Notice I said IF because chart watching is an art and not a science.

sp-monthly

The final chart above shows the monthly S&P 500 index compared to its 10 month moving average and includes a Relative Strength Index (RSI) – a momentum-only measure of the speed and rate of change of a price move. In this one, I’ve drawn circles around times where the RSI is showing readings that are either overbought (where there are too many bulls – a contra-indicator) and oversold (too many bears – also a contra-indicator). I have also drawn circles around times when the S&P has crossed over its 10-month moving average line. You can see that when they both happen, it represents a fairly long-term change in trend. At the moment, we have the RSI showing an over-bought reading but the S&P still above the 10-month moving average. IF history provides any indication as to patterns within the stock market, and the S&P index crosses its 10-month moving average to the downside, the stock market should weaken and turn down, possibly into more than just a correction.

Notice I said IF because chart watching is an art and not a science.

These are three fairly important charts for me and at the moment they are flashing caution. We have built up a 4% to 5% (of equity exposure) cash cushion in client accounts as these charts started to turn negative. We will hold onto that until we see definitive sighs of a trend change to the downside – if it happens.

I want to be clear – there is no guarantee that the market will go down. It could continue higher or even move sideways for a time. In fact, here is where the art of chart reading comes in – this chart shows that the top three may be flashing false signals:

sp-with-regression-channels

This chart shows the S&P 500 Index with a regression channel that I’ve drawn. You can see that the market has moved within this channel for the past 6+ years. The channel is marked by upper and lower boundary lines with a mid-point line. The current move by the market is very consistent within the upper half of the channel. This type of move indicates a strong uptrend, and until we see it move into the lower half of the channel the trend is definitely in tact.

So for now I am going to exercise my art degree and carry on with the plan to be cautious but remain 95% invested until all four of my indicators tell me that a correction is near.

Mark

I’ll Take the Double

Monday, May 4th, 2015

ctsh

On May 28, 2013, we purchased our position in Cognizant Technology Solutions at $64.20 (which split 2 for 1 on March 10, 2014) and today hit $64.71, up 10% on the day. We were able to double our investment for a bit over a 100% gain in under two years.

As you look at the chart above, there is one thing that really stands out to me – during 2014, this company traded in a side ways to down pattern, with a loss on the year of about 20%. We opted to hold onto our shares during this time because our analysis of the company showed that it was operating at the top of its game.

Below I’ve excerpted some of the items from our internal analysis of the company:

1. Operating Performance

ctsh-operating-performance

Earnings Per Share growing at > 21%
Sales growing at > 25%
Book Value growing at > 21%

These are great metrics and indicate that the company is operating on all cylinders.

2. Operating and Valuation Ratios

ctsh-key-statistics

As you can see from our Key Statistics grid, this is a company that is an investors dream. A couple of highlights from this grid are: 1) Its return on invested capital – a measure of how efficiently management is using investor capital to generate returns – is three times is cost of capital, a truly amazing achievement; and 2) Its PEG ratio is 1.29, indicating this company is currently trading at just 29% above its growth rate, making it somewhat of a bargain particularly in light of #1 above.

3. Valuation

ctsh-over-under-valued

The grid above is one measure of how I calculate whether a company is over-valued or under-valued at current prices. I like to compare the current price of the company’s stock to its historic price multiple – but for this calculation I blend together the price-to-book, price-to-cash flow, and price-to-earnings multiples for the past 10 years. You can see that based upon this calculation, the company is undervalued even after its run higher over the past two years.

4. Proprietary Ranks

ctsh-ranks

I’ve written on the blog several times in the past about our proprietary ranking system that ranks a universe of 6,000+ stocks on a bell curve based upon two sets of ratios. One set of 18 ratios provides an Earnings Growth rank and the other set of 10 ratios provides a Financial Strength rank, with zero being the worst and 100 being the best. Since it is a bell curve rank, the bulk of the ratings fall in the middle with few companies at each end. Cognizant ranks quite high on both measures, providing that enviable position of having strong and sustainable earnings growth while not taking too much risk from a balance sheet perspective.

5. Free Cash Flow

ctsh-free-cash-flow

Free cash flow is the amount of cash available for dividends, share buybacks, book value growth and future shareholder rewards AFTER investment in property, plant and equipment. It is an important metric in a large cap company and I prefer to look at it in comparison to its history. As you review the bar graph above, you can see that CTSH has had a steadily growing FCF over the past decade and is supportive of the return on invested capital calculation above in identifying how efficiently management is operating the company to the benefit of the shareholders.

After a review of the financials I am comfortable continuing to hold onto this investment even though we have doubled our initial investment in it. In today’s investment world, investors have too short of a time-frame for their investments. The price performance during 2014 likely caused many investors to sell out of this holding without analyzing its operating performance.

The pressure on investment managers to beat the index on arbitrary time-frames like monthly, quarterly and yearly cause many to dump potentially lucrative holdings in favor of a momentum stock that is doing great today but might not have the operating performance to sustain a price move like Cognizant’s.

The lesson to be learned from this investment is that stock price will ultimately reward superior operating performance. It is not always easy to stick with a company whose stock price is not following the market, even when the company’s operating performance shows that the market is mispricing it. The mispricing is actually an opportunity to buy (or hold onto it if you bought earlier) that will ultimately reward you in a meaningful way – maybe the mispricing will not resolve itself as quickly as CTSH did but ultimately it will. Investors and investment managers just need to look longer term and not surrender to the pressures of trying to beat the index in the short-term.

Mark