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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% |