Archive for April, 2012

When Resistance Becomes Support

Wednesday, April 25th, 2012

S&P 500 Index

Earlier in the rally, I wrote about 1370 being a resistance area for the market – we finally broke through it in late February, but the rally ran out of steam the past couple of weeks and the market pulled back.

As you can see on the chart above, I’ve drawn a line around 1370 to make it easier to spot this level. So far, this pullback has been a textbook example of an “orderly” correction – around a 5% pullback to a support level.

One of my axioms is my Rule of Three. Whenever a market breaks support or resistance, it has to do so by either a passage of three days time on the other side of the resistance or support level, or it has to do so by 3%. If you look back at the late February breaking of resistance, it was unable to sustain it for three days, so it pulled back a couple percent. Then in early March, it successfully passed the Rule of Three and the market headed up another 5%-ish.

After the end of March, a lot of investors began to take profits on the big run higher in the first quarter. Then Europe started to come back into the news and the Fed released some minutes that said they weren’t going to immediately do another round of QE stimulus. This caused investors to sell stocks further, pulling the market back 5%-ish to support.

If you look at the graph closely, you will see that we have flirted with breaking support but haven’t been able to sustain three days below 1370. Then something comes along and acts as a catalyst to revive investor enthusiasm: Apple’s earnings. If the largest company in the index can increase its earnings 97% year-over-year, maybe things really aren’t as bad as the talking heads on TV want you to believe (in reality, most of them likely had short positions and were trying to scare the market into a fall so they could profit from it).

So far, earnings season has been pretty good. There have been some isolated cases of disappointment – like Conoco Phillips missing their estimates in a major way due to the falling price of natural gas – but for the most part things have been good – just look at Caterpillar which announced today that it had its best quarter EVER (and in one of those market anomalies that is nearly inexplicable, the stocks lost 4% on this news, so we bought it).

With what appears to be a successful test of support and the beginning of another leg higher in this rally, we began to put the cash we have on hand from selling near the recent top back into the market. The CAT purchase was just one we made today – most were focused on the large cap exporters – but, alas, I didn’t buy my nemesis, Apple. After such a large move overnight and today, investment basics say that it will pull back as short-term traders sell to capture their unlikely profit.

But, I’ve been wrong on Apple a lot. I started researching it today and I have a handful of clients that already own it with at $78 cost basis. I bought a starter position for them because they had the cash available and figured that if it pulled back we’d make sales for everyone and fill out a full position – sadly, the stock never looked back from that level. The unfortunate thing is that the standard analysis that gives me a buy level just doesn’t work with this company – it is too successful and popular to ever pull back enough to make it a value stock – whatever will be, will be with this one.

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OK, its not classic rock, but have fun with it anyway 🙂


Apple, My Nemesis

Tuesday, April 24th, 2012


Yes, I got greedy.

Based upon both AT&T and Verizon’s reports of slowing iPhone sales, I assumed Apple would report lower sales and their stock price would get a panic sell-off allowing me to buy it as others were in panic mode. Do I feel dumb.

Apple reported earnings that blew away expectations from everyone. Where did it come from? iPhones are now passee’ , it seems – iPads rocked their earnings to the stratosphere.

My plan (is that the best laid plans of mice and Mark?) was to allow them to report, and based upon the target price analysis I posted a few days ago plus the obvious oversold technical readings I’ve circled on the chart above, buy it.


Apple reported their earnings after the market closed today and in after-hours trading it was up 8% – ack – not a devastating issue, but I’d prefer to have bought the stock the other day when I decided I should based upon the target price analysis and booked the profit.

What to do now? Invest what you see, not what you believe (my axiom for successful investing) and that means watching the chart for an entry point and to pull the trigger when the opportunity presents itself.


Home Prices

Tuesday, April 24th, 2012

Case Shiller Index

I keep reading about the end of the housing crisis on various news and investment sites, but today we get the release of the Case Shiller Housing Index and it is the 6th month in a row of falling prices. You can see on the graph above that even though we had a slight recovery after the huge fall between 2006 and late 2009, the index is now in a pattern where it is slowly drifting lower.

Obviously this is not something that any politician of either party in Washington wants to see, and in spite of the Fed being “non-political” in its work, I’d expect to see some sort of stimulus come from the Fed aimed at raising home prices before the election in November.

From an investment perspective, this seems like confirmation that the stocks of companies that are focused on helping investors maintain their current residences should continue to outperform. Have you seen Home Depot or Sherwin Williams? They are both rocking.

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Valuing A Company

Friday, April 20th, 2012


One of the more frequent questions I get is how to set a target price for a specific stock. After that, people ask me if they should buy Apple at these prices.

You can look at the chart of Apple above and see that it has had a HUGE run higher in recent months, but is in the process of digesting that run-up as it flirts with its 50-day moving average.

I thought maybe I’d answer the first question by looking at Apple. However, nothing that is written in this blog should be considered as advice to buy or sell Apple or any other specific company. The following is an exercise in how an investor looks at a company to determine if there is potentially enough upside in the price to warrant researching it further.

When I look at a company to see what it might be worth, I look at five different calculations to see what the stock price could potentially reach if all things stayed the same.

Please note, however, that all things never stay the same – the inputs to the formulas below are ever-changing, whether they are corporate sales, GDP, inflation, investor willingness to pay current or future valuations, average growth rates, etc.

Let’s take the easy one first – it requires no math:

Analyst Consensus Target Price: This is easy, you just look it up on the internet. Right now, the Analyst Consensus Target Price is $678.84. Where does this come from? Basically, all of the target prices for Apple that are published by the investment firms that follow it are averaged to come up with this number.

The upside of this methodology is that it is easy to find; the downside is that all of the various methodologies are averaged out of the process so you have no clue as to what the inputs are.

Now the rest:

Sector P/E X Forward EPS:
Again, this one is pretty easy. You take the valuation of its competitors in the same Industry Sector and multiply it times the projected earnings per share for the company. In this case, Apple’s competitors trade at a valuation of 19.75 times current earnings compared to Apple’s 16.73 times. The logic behind this methodology is that if Apple were to trade at the same valuation level of its competitors, based upon next years estimated earnings of $50.85 per share, Apple would be worth $1,004.29.

The upside of this methodology is that the data is easy to find on the internet; the downside is that it ignores many company-specific issues that make its valuation different from that of its competitors.

Discounted Earnings Yield:
The formula for this one begins to get a bit more complicated. In essence, you are calculating the future value of the earnings for the company and discounting it by the earnings yield (the inverse of the P/E ratio). The formula is a bit more complex than that, but it is another methodology that I have found useful over the years. This calculation give us a value of $928.12.

The upside of this methodology is that you can easily find the P/E ratio and calculate the earnings yield; the downside is that calculating the future value can be a bit more involved than the multiplication required in the previous method.

Discounted Cash Flow:
This is the most involved method I use and requires several inputs, including calculating the free cash flow for the company, determining an appropriate growth rate, calculating the weighted average cost of capital for the company, calculating the cost of the company’s equity and debt, calculating the net present value of the future cash flows, and calculating a terminal value for the company.

I generally calculate a stream of cash flows 50 years into the future for this methodology, and based upon the 50 year earnings stream, we get DCF value of $990.

The upside of this methodology is that a company’s earnings ultimately determine their stock price (which is why earnings season is so important and discussed so much on business television); the downside is that it is very involved and requires collection of a lot of data.

The One I Learned In School:
In my finance and investment classes a few decades ago [for those of you who remember Campbell Evans, he was my Securities teacher at Illinois Wesleyan], the way I was taught to calculate the target price was to take the current cash and marketable securities on a company’s balance sheet and add to it their current earnings multiplied by some multiple of those earnings. Generally, that multiple was the P/E ratio or the P/E ratio adjusted by the long-term growth rate for the company.

When you do the math for this methodology, you come up with a value of $1,044.94.

The upside of this methodology is that all of the information is readily available on the internet – and you can easily adjust the valuation for company specific issues buy lowering or raising the multiple to some number you believe to be more reflective of the situation. The downside is that it is simply a variation on the earlier P/E based valuation.

Oddly enough, though, many investment professionals still use this methodology to calculate their targets, but instead of the P/E they use some static multiple, like 8, 10, or 12 as their baseline then adjust up or down based upon their positive or negative view of the company’s likelihood of achieving their earnings in the future.

So, which one is better?

Each have their place – I prefer the Discounted Cash Flow because it uses the least amount of subjective information to derive the price. The biggest subjective decision you make is what to use as the growth rate for your 50 years of cash flows and I choose the most recent GDP growth rate. Others choose the current or expected inflation rate – while yet others choose a static number like 2%. I think it is more important to choose a growth rate and apply it consistently than which one you choose – just be comfortable with whatever you use and have a reasonable basis for it.

Unfortunately, it would be very difficult for the average investor to calculate the DCF value of a company so they would need to choose one of the other methodologies – or just rely upon the Analyst Consensus Target that they find on the internet.

As you can see from the numbers above, the Analyst Consensus Target is much lower than the other methodologies – and potentially for very valid reasons.

Earlier I mentioned that these were valuations in a static world where nothing is anticipated to change – it could be that the analysts have adjusted their valuations downward for some non-static events, like consumers finding some product that they prefer to iPads and iPhones, which would negatively impact Apple’s earnings in the future.

The calculations above are all based upon extrapolations of Apple’s historic numbers in some manner – and none of them include any what-if scenarios that analysts may include to provide a discount to future earnings.

We’ve all heard about the “art” and the “science” of some activity. When I calculate a target for something I am buying, I always include a discount for the unknown – in the investment world its called a Margin of Safety. Sometimes its as high as 50%, sometimes not – this all part of the “art” of investing that cannot be compensated for by the “science” which in reality is math. Obviously the math is critical, but it is not 100% of the answer.

In the end, if you are investing on your own and want to set a target, you can pull one of the above methodologies out of your pocket and calculate it or you can use the Analyst Consensus straight from the internet – but don’t ever buy something without having a profit goal in mind.

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2012 Year-To-Date

Monday, April 9th, 2012


We have had a pretty good year so far in the stock market overall when you look at the YTD return of the S&P 500: up 11.83%. If you look at the bar chart above, you can see that financials, technology and consumer discretionary stocks are the big winners.


In looking at the major markets, you can see that the NASDAQ is the big winner with Emerging Markets following in a distant second place.

What’s changed from 2011? Investors have been underweight stocks compared to bonds and cash since the stock market crash of 2008. They have begun to feel its time to make a shift back to stocks from bonds and cash, given the following things: (1) corporate earnings have been strong the past couple of years; (2) the Federal Reserve has stated that it is going to keep interest rates low until 2014 at least; (3) US Unemployment has dropped to 8.2%; (4) the European Debt Crisis is out of the news (not necessarily solved but we aren’t seeing rioting in Greece everyday on the TV); and (5) its an election year and stocks tend to move higher in election years.

But is it time increase overall equity levels as many are doing today?


If you look at the graph above, you can see that we have been in a trading range since 2000, and that we are up significantly from the lows of 2009. We have ridden the market up and capitalized upon those gains, but if I were someone that has been underweight stocks during this time period, I would not be moving money into the market now.

We are currently positioned with about 5% cash and 5% in our contra mutual fund position in the stock portion of client portfolios. A couple weeks ago, we so half of our 10% allocation to the equity index to raise cash and added to our contra position to bring it up to 5%. These two actions were designed to protect against a market pullback that we were long-overdue to experience. Since the October 2011 lows, the market has virtually moved straight up – that cannot happen forever – so we made these moves as part of an overall risk management strategy.

But the real question is whether we will experience the same type of market pullback we saw last year from May to October. Anything is possible, so we want to have some cash and contra positions in portfolios to use to reinvest in favored stock positions if they pull back.


I often write on the blog to invest what you see, not what you believe. In looking at the year-to-date chart above, you can see that the market has dipped below the 20 day moving average and is converging on the 50 day moving average. If we dip below the 50 day line, my plan is to book some profits in some of our higher beta holdings (more volatile) and wait for the market to stabilize. When it does, we will add that cash to holdings that have underperformed (assuming the fundamentals are still sound) and manage the pull back accordingly.

In the meantime, the uptrend is still positive, and in spite of it losing steam, there is no reason to over-react.