PE Multiple

Text Box: Wiser Trader Stocks and Options Newsletter
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Issue No. 43 – September 12, 2005 Prescott, Arizona Systems@WiserTrader.com

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1.0 Trading

How important is the price to earnings (PE) multiple? This week let’s take a look at how well last year’s PE could have been used to predict current market prices.

1.1 PE Multiple

The analysis involves comparing the year ago PE of a group of stocks with their subsequent 1 year price performance. Beginning with 8,600 stocks, a filter was used to find NYSE, NASDAQ and AMEX stocks that had earnings and were priced above $4. The study eliminated Advanced Depository Receipts, Over the Counter Stocks and Exchange Traded Funds. The result was a group of 3,321 stocks shown in Figure 1. The chart on the left shows an expected inverse relationship between PE and 1 year price gain, illustrated by an arbitrary idealized red line.

FIGURE 1

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However, zooming in closer, the chart on the right shows that even for low values of PE, one could have obtained a wide range of possible outcomes.

The 3,321 stocks were sorted into seven PE ranges and used to plot 52 week price gain histograms. The data is summarized in Figure 2. Market data for the past year shows that, no matter what PE they had a year ago, about 25% of all 3,321 stocks had zero or negative net gain for the year. To state it positively, if you had picked a large sample of stocks randomly, the probability of some kind of gain in one year was 75%.

Another interesting result that was that about 19% of stocks had gains ranging from 25 to 50%, nearly independently of their PE ratio.

Patterns that did emerge based on PE were that mid PE ranges had a predominant number of stocks with price gains from 0% to 25% while the extreme PE ranges (the highest and the lowest) had the predominant number of stocks with price gains of 50% to more than 100%.

FIGURE 2

The percentages of stocks in Figure 2 can be treated as probabilities of price gains for PE ranges over the past year only. While a certain PE range may influence the probability of a 1 year stock price gain or loss, it should be understood that PE alone does not determine the future price increase of a stock. The reason for this can be understood by considering that the average PE varies for each industry. For example the average PE for the Iron and Steel industry is about 5 while for Oil and Gas Pipelines it is about 25. How the PE for a company compares to the average for its industry is a good subject for the next level of analysis.

2.0Market Analysis

Before the disaster along the southern coast, some analysts expected a short term bounce to begin after Labor Day. It has begun. Overall, investors remain primed for a fourth quarter rally. The hurricane is expected to boost rebuilding and earnings expectations remain high for the fourth quarter. Yet here we are again on the brink of earnings warning season and the possibility of choppy markets ahead.

Figure 1 compares index tracking stocks for the major averages with Sector SPDR’s.

FIGURE 1

Market sentiment is shown in Table 2A.

Table 2A

VTO Market Sentiment Indicators

Sentiment Indicator	Current	Last Week	2 Weeks Ago	Complacent	Cautious
VIX **	13.57	13.72	13.42	< 20	> 50
VXN ***	15.67	15.37	16.16	< 30	> 70
Put/Call Ratio	0.612	0.814	0.576	< 0.6	> 0.7
%Bulls - %Bears	23.8%	31.9%	34.8%	> 29%	< 20%
Above 20 day SMA = Sell signal. * Above 20 day SMA = Sell signal.

Figure 2 compares index tracking stocks with five leading ETF’s for the week.

FIGURE 2

In Table 2B, the broader market edged upward for the week. Key industry ETF’s in Table 2B are Biotech and Semiconductors which confirm the NASDAQ. Transportation confirms the Dow Jones Industrial Average according to Dow Theory. Banking and Financials are confirming indicators for the S&P 500. Gold and Real Estate are respective indicators for the inverse health of the currency and consumer spending.

Table 2B

Index Tracking Stocks, Key Industry ETF’s and Sector SPDR’s

	1 month	1 wk ago	2 wks ago	3 wks ago	4 wks ago
SPY (S&P 500)	1.3%	1.9%	1.3%	-1.4%	-0.5%
DIA (DOW)	0.7%	2.1%	0.7%	-1.7%	-0.3%
QQQQ (NASDAQ 100)	1.0%	2.2%	0.8%	-0.9%	-1.0%
IWM (Russell 2000)	2.9%	1.8%	2.6%	-0.9%	-0.6%
GLD, GOLD	0.8%	1.3%	1.5%	0.0%	-2.0%
RKH, Banking	0.0%	0.8%	1.0%	-2.4%	0.6%
IYT, Transportation	-3.5%	-0.9%	-0.7%	-1.1%	-0.9%
SMH, Semiconductors	2.8%	2.4%	0.5%	0.1%	-0.3%
BBH, Biotechnology	5.0%	1.7%	3.7%	-0.3%	-0.3%
IYR, Real Estate	3.2%	1.4%	2.2%	0.4%	-0.8%
OIH, Oil	3.6%	2.7%	4.7%	-0.1%	-3.5%
XLE, Energy	5.2%	3.6%	6.2%	-0.4%	-4.0%
XLU, Utilities	5.3%	1.3%	2.6%	1.6%	-0.3%
XLB, Materials	-3.1%	1.8%	0.8%	-3.0%	-2.7%
XLI, Industrial	-0.1%	1.6%	0.5%	-1.4%	-0.7%
XLK, Technology	1.3%	1.5%	0.7%	-0.8%	-0.1%
XLV, Healthcare	2.1%	2.5%	1.9%	-1.2%	-1.1%
XLF, Financials	0.5%	1.3%	1.2%	-2.1%	0.1%
XLP, Consumer Staples	1.2%	1.2%	0.6%	-1.0%	0.4%
XLY, Consumer Discretionary	-1.8%	2.3%	-1.2%	-1.2%	-1.7%

3.0 Procedure

The following watch lists contain stock candidates for consideration. They are not necessarily trades. Categories include check lists for insider buying and cash rich companies, as well as, filters that employ stock picking methods used by six important master traders. Stocks are ranked by where their current price falls in the range defined by their 4 week highs and lows. Stocks at their 4 week highs are ranked 100% while those at their 4 week lows are ranked 0%.

The “Reference” is the date that a stock passed the indicated filter and was added to or returned to the list. The “% Change” is how the price has changed since the reference date. Stocks that are down 10% or more after being listed are removed. The “% from Max” is the percentage the price has declined from the maximum price reached since the reference date. Stocks that are down 8% from their highs after being listed are flagged in yellow. Stocks that are down 15% from their highs after being listed are removed. More information on filters is available on the web site.

A performance summary of filtering techniques for check lists and master trader selection methods is given in Table 3A.

Table 3A

Stock Filter Summary

Filter	Avg. % Change Since Listed	Avg. % Change Friday	1 Month	1 Week Ago	2 weeks Ago	3 Weeks Ago	4 Weeks Ago
Net Insider Buying	7.2%	-0.3%	7.1%	1.8%	0.0%	6.7%	-1.3%
Cash Rich Companies	0.4%	0.0%	4.2%	0.4%	0.3%	1.2%	2.2%
Growth Momentum Stocks	14.1%	1.3%	1.9%	2.3%	4.2%	-2.0%	-2.4%
Lynch Stocks	12.9%	1.0%	1.5%	1.5%	2.8%	-0.5%	-2.2%
Buffett Stocks	25.8%	1.4%	2.6%	2.1%	3.0%	-1.0%	-1.4%
Graham Stocks	9.9%	1.4%	3.8%	1.5%	2.7%	0.6%	-1.0%
Templeton Stocks	7.1%	0.6%	0.9%	1.6%	1.0%	-1.0%	-0.7%
Zweig Stocks	11.7%	1.9%	7.4%	4.7%	5.6%	0.2%	-3.0%
Average	11.1%	0.9%	3.7%	2.0%	2.5%	0.5%	-1.2%

Key

Passed Recent Filter

Companies that have experienced net insider buying within the past 6 months of 5% or more of issued stock are listed in Table 3B. These stocks should also appear in one of the master trader screens or meet additional screening criteria before being given serious consideration. This list is a mixture of stocks that are optionable and those that are not.

Table 3B

Net Insider Buying Check List