Examining Dualing Market Outlooks

Does anyone else find it pretty strange that two people can look at the exact same set of data and reach two dramatically different conclusions? I'm speaking of market strategists who try and determine if the overall equity market is overvalued or undervalued. The bulls think we are 20 or 30 percent undervalued and the bears see the exact opposite scenario. How can people differ that much on the outlook for the domestic stock market? It's not like we're are trying to value a single company, where I could understand widely varying outlooks. The stock market as a whole can't be overvalued and undervalued at the same time.

The key to analyze this dichotomy is to look at the S&P 500 P/E ratio, which is the most widely used metric to value the overall market. This isn't as simple as it sounds though. You arrive at different numbers depending on if you use the trailing twelve month (TTM) P/E or the forward P/E. Personally, I use forward P/E ratios when valuing stocks, because equities are claims on future earnings, not profits already earned. However, the most bearish market strategists use trailing numbers because doing so results in higher P/E ratios, which imply higher valuations. For the purpose of this piece, I'll use TTM P/E ratios, mainly because historical data is easier to find.

Another point of contention is which earnings calculation to use. The two most commonly cited are operating earnings and GAAP earnings. Operating earnings are meant to gauge how much cash a firm's operating businesses are generating, whereas GAAP numbers are really more of an accounting standard and don't always reflect true profitability. For instance, one of the biggest contributors in GAAP earnings is stock options expense. Accountants insist that companies issue GAAP income statements that place a value on expenses incurred by issuing stock options, even though no economic cash cost is incurred.

Currently, the P/E on the S&P 500 index is anywhere between 15.4 (forward operating earnings) and 18.0 (trailing GAAP earnings) depending on which of the four measures (forward vs trailing/operating vs GAAP) you use. I don't think we need to agree on which P/E to use to analyze whether or not the market is wildly overpriced or underpriced. For the most part, the bears think P/E ratios should be lower, or will be lower shortly. The bulls think if P/E multiples do anything, they should go up, not down.

Keep in mind, I am referring only to those people who think the market is meaningfully mispriced right now, say by 20 percent or more in either direction. I fully understand that this is only a subset of all market pundits. I'm simply interested in looking at the dichotomy that exists between them.

Let's take a look at an interesting chart that should shed some light on this debate. The graphic below shows the historical trailing P/E of the S&P 500 index (blue) along with a five-year moving average (black).

As you can see from the chart, the stock market typically trades at a P/E of between 10 and 20. Depending on which number you use, we are currently either right smack in the middle of that range, or on the upper end of it. If you are using P/E ratios as your yardstick, you really can't make a compelling argument that stock prices are dramatically too high or too low.

The real question in this analysis, if we assume the historical range is a pretty good guide to stock market valuation, is whether we should be closer to 10 or 20. How much investors are willing to pay for equities can depend on many variables, but the most important ones are interest rates and inflation. Don't take my word for it though, both logic and historical statistics back up this assertion.

Since stock prices reflect future earnings discounted back to present day values, there is a negative correlation between interest rates and stock prices. When rates are low, investors are willing to pay higher multiples of earnings, and vice versa. Inflation measures have the same effect on demand for equities. When inflation is high, the "real" (net of inflation) return on stocks goes down or becomes negative, which crimps investor demand for equities, lowering multiples.

Since the economic backdrop is crucial in determining the appropriate valuation level for stocks, the fact that the United States currently is operating a growing economy in a low interest rate, low inflation environment sheds a great deal of light into where stock prices might trade. The middle or upper end of the historical range is not only not unrealistic, but it makes a lot of sense.

Making the argument that P/E ratios should be dramatically higher is simply not prudent given the historical data. Defending a P/E toward the low end of the range also isn't very compelling given the current economic backdrop. As a result, I think a simple look at history, coupled with a basic overview of current economics, shows that the market is neither wildly overvalued, nor wildly undervalued.

So Much For That Theory

If you want to know just how difficult it is to predict short term market events, such as interest rate moves, just look at what happened over the last two weeks. I wrote back then about how the futures market was pricing in a 50 basis point rate cut and postulated that the odds of no cut or only 25 basis points appeared to be much higher than the market was indicating. It turns out that neither the market nor my contrarian view two weeks ago turned out to be right.

By the time the Fed meeting came around yesterday afternoon, the market was only expecting 25 basis points, which I obviously agreed with. Then out of nowhere we get a 50 basis point cut, the bulls were ecstatic and the shorts got burned big time. The end result was a 336 point jump on the Dow, the biggest single day point gain in about 5 years.

Rather than try and predict why the Fed did what they did, or what they will do in the future, let's focus on what yesterday's action does. First and foremost it was a positive symbolic move that the Fed does have the market's back. We can argue if such a role is in their official job description or not, but that's another conversation entirely. I'm not sure why they waited so long if they thought a dramatic 50 basis point cut was needed, but maybe they are hoping decisive action will prevent further deterioration that would require more cuts in the future.

An important point regarding rates is the effect on the housing and mortgage markets. Remember, for all of those home owners who will desperately be trying to refinance their adjustable rate mortgages into fixed rate loans, this rate cut won't help them. Fixed rate mortgage rates are based on long term bond rates, not the Fed Funds or Discount rate. The move will help those with variable rate home equity loans and credit card debt (which are generally based on the Prime rate), but I don't think a half a point change in rate, or even a full percentage point if we get more cuts later on, will dramatically alter the ability of consumers to pay their bills on time.

The main problem with the housing market is supply and demand and overly excessive pricing. Despite press reports to the contrary, most people can get a mortgage if they want to buy a house. For those sub-prime borrowers who can't get a loan, now isn't the time they' be looking for one anyway (they have already gone down that road). Instead, they will either be forced pay their mortgage, refinance into a fixed rate mortgage (which the banks can make a profit on and therefore are willing to offer), or lose their home and begin renting again.

So what will really help the ailing housing market? In my view, above all else, it's reasonable pricing. Not only can most people still get loans, but another myth out there is that you can't sell your house. Well, that's not really true. What is true is that you can't get top dollar for your house or always make a profit on every property that you purchase. However, if you price your home competitively, you will find buyers.

Want proof? How about what Hovnanian Enterprises (HOV), one of the larger home builders in the country, did recently. HOV just completed a 3-day sale on their homes, which they dubbed the "The Deal of the Century," where they slashed prices by up to 25% or $100,000 in an effort to get rid of inventory. The results were beyond impressive. Hovnanian either sold or received deposits on 2,100 homes in just 72 hours. That compares with 2,539 homes sold in the entire quarter ending July 31st!

Now, some press reports compared these numbers directly to gauge the sale's impact, which is not correct given the 2,100 number was gross sales and 2,539 was a net sales figure. If you use HOV's most recent cancellation rate of 35% you get net 72-hour sales of 1,365 homes. But still, the implications are very strong. If you price your homes aggressively as HOV did, there are plenty of willing buyers. By doing so, Hovnanian sold more than 6 weeks' worth of homes in only 72 hours.

Full Disclosure: No position in HOV at the time of writing

Best Buy Crushes Estimates, Silences Consumer Worries

Judging from the stock market in recent months, one would think that every consumer related area is extremely weak. The worst performing groups by far this year have been consumer credit focused financials and retail. I continue to bottom fish in these areas because the stocks are pricing in some very dire profit outlooks, which I don't entirely agree with.

Results this morning from Best Buy (BBY) seem to support the claim that the consumer is not in as bad a shape as many would have you believe. In case you missed it, Best Buy reported earnings (for the quarter ending September 1st) of 55 cents per share, an impressive 11 cents above estimates of 44 cents. Sales grew 15% with comps rising 3.6%. The company now expects full year earnings to be in the upper half of guidance ($3.00 to $3.15) so we're likely looking at 2007 profits of around $3.10 per share.

Best Buy stock has been hit hard, closing yesterday at $44+ per share. I think the stock is attractive in the mid forties, as I have written about before (Best Buy Looks Attractive), given a 2007 P/E of 14. Investors are really going to focus on 2008 as we close out this year, and estimates are nearly $3.60 for next year. Should a leading retailer growing its business 15% really trade at 12 times forward earnings? Maybe if the consumer was really, really hurting, but today's results from Best Buy do little to support that argument.

Full Disclosure: Long shares of Best Buy at the time of writing

Crude Oil Might Be Ripe for Some Profit Taking

Short term movements in energy markets are very much tied to supply and demand. Seasonal variations in the dynamics for crude oil and natural gas can allow for some very successful trading in these areas. With crude oil prices sitting around record highs of $79 per barrel, and the summer driving season winding down, it might be prudent to take some chips off the table if you purchased shares of the United States Oil Fund (USO) as I suggested back in January when the crude oil ETF was down 40% from its high.

Since then shares of USO have risen more than 35% to $59.43. This is not to say that I would get off of the energy train for good. But if you have an elevated exposure to crude oil specifically, maybe take some profits. Oil prices could go up further if we get any strong hurricanes in the next month or two, but the seasonal oil play is nearing an end, so lower prices would not be surprising as we head into the winter.

Rather than move out of energy completely, moving some crude oil funds into natural gas would be a good value alternative given that natural gas prices are depressed right now. Winter heating season is coming soon, so there will be more potential catalysts for that commodity in coming months. Natural gas plays would include the previously recommended United States Natural Gas Fund ETF (UNG), Chesapeake Energy (CHK), as well as Select List pick Gastar Exploration (GST).

You may have noticed that Warren Buffett is trimming his position in PetroChina (PTR), the large Chinese oil producer. I doubt these actions are being made on a short term trading prediction (Buffett is the epitome of a long term investor), but it reinforces the need to buy low and sell high to maximize returns.

Crude oil is on a roll right now, and that fact makes it hard for some people to not want to keep riding the wave, but selling into strength is a crucial strategy for those looking to maximize long term investment returns. Buffett's purchase of PTR as a play on both China and crude oil, before those two areas were popular investments, should go down as one of his best investments in recent history. And yet, he isn't being shy about taking some profits.

Full Disclosure: Long shares of CHK, GST, and UNG at the time of writing

Insider Selling Could Mean Anything, Whereas Buying Can Only Mean One Thing

At Peridot Capital, I tend to ignore insider selling completely. Sure, a lot of sales inside a company can indicate management feels their stock is overpriced, but there are dozens of other reasons top brass sell stock, and they are never required to give the reason for their actions. Investors should be able to tell if a stock is grossly expensive or not on their own, if they indeed manage their own money, so insider selling data really can't be relied upon.

Insider buying, however, I believe is crucially important. While I can make a laundry list of reasons why someone chooses to sell a stock, the reasons to buy are much fewer in number. In fact, there's only one (to make money). It's not surprising that studies have shown much more meaningful correlation to stock performance and insider buying, as opposed to insider selling. And with that, I'll leave you with the following Associated Press story that ran on Friday evening. To those who think there are bargains among the wreckage of the latest correction, you're not the only ones...

AP: Insider Buying Set Records in August

Friday September 7, 6:17 pm ET

NEW YORK (AP) -- Insiders purchased shares of their companies' stock at a record pace in August, analysts said, as credit market deterioration threw stocks into a tailspin during the month. The trend of buying among insiders, who are typically long-term investors, was one of the few bullish signals last month, said InsiderScore.com, a Web site that tracks insider transactions.

According to Thomson Financial, insiders drove buying volumes to their highest monthly levels since 1990, with $465.5 million in purchases.Insiders in the energy, retail and insurance industries led the buying spree, said InsiderScore.com analysts in a research report released Wednesday.

In the energy sector, insider buying was at its strongest since the spring of 2005, boosted by large purchases by RPC Inc. Chairman Randall Rollins, Cheniere Energy Partners LP Chief Executive Charif Souki and insiders at other companies. Schlumberger Ltd. Director Michael Marks and Nustar GP Holdings LLC Director William E. Greehey also bought shares as their companies' stock came down from 52-week highs.

In the retail sector, which was hurt as economic uncertainty slowed shopping this summer, top executives at several companies bought stock as shares fell to 52-week lows in August. American Eagle Outfitters Inc. Chairman Jay Schottenstein and other insiders bought 184,575 shares. Barnes & Noble Inc. Chairman Leonard Riggio bought 100,000 shares, his first purchase in two years. The CEO of Best Buy Co.'s international operations bought 11,300 shares, the largest insider purchase of the electronics retailer's stock in more than two years.

In the insurance sector, more than 10 insiders bought shares at Conseco Inc. after the company's stock plunged in August. Also, Prudential Financial Inc. Chief Financial Officer Richard J. Carbone bought 10,000 shares last month. Unitrin Inc. and American Financial Group Inc. were among other insurance providers that reported large insider purchases in August.

In other sectors, Yahoo Inc. President Susan Decker and Director Arthur Kern bought more than 65,000 shares of the Internet search company, which has slipped against rival Google Inc.

Also, three directors of American Express Co. bought 63,000 shares of the credit card company in August.

Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

You would think that with everything Fed Chairman Ben Bernanke has said publicly thus far regarding the current turmoil in the mortgage and credit markets, the market might be at least somewhat doubting that a Fed Funds rate cut is coming later this month at the next FOMC meeting. After all, Bernanke came out and said the Fed is not responsible for bailing out lenders and consumers who made bad decisions in a loose lending environment. Quotes like that should at least temper people's expectations a little bit that a rate cut this month is essentially guaranteed. Well, that does not appear to be the case.

As of late Wednesday, a 25 basis point cut was fully priced into the market and there was a whopping 72% chance of a 50 basis point cut also priced into futures quotes. Given the actions we have seen from the Fed thus far (namely choosing to inject liquidity rather than lower interest rates for consumers) and the words they have chosen in public speeches in recent weeks, I have to take "the under" on the Fed Funds futures bet.

Now, that is not to say that there won't be a rate cut. That could surely happen, and you could justify it several ways. It just seems to me that the Fed wants to try every other option they have at their disposal before giving in with a rate cut, which many see as bailing out people who made ill-advised decisions and thus contributing to a moral hazard issue.

Because of that, I think saying there is a 100% chance of a cut this month is overly optimistic for interest rate bulls. And a 72% chance of a 50 basis point cut is even more aggressive. Right now, I'd put the odds of a cut of any magnitude between 50% and 75% based on what Bernanke has said and done so far.

I bring this up not because I think people should speculate in the futures markets, but because it's important to understand what is currently priced into the marketplace. If we don't get a cut later this month, which I think is certainly more probable than the markets currently are telling us, then stocks are going to sell-off. That is what we open ourselves up to when the market prices in something as a certainty even though there is still an undeniable fact that nothing is certain about the September FOMC meeting.

And even if we do get a cut of 25 basis points, we could still see the market not react positively because more than half of people right now expect 50 basis points (who knows what that number will be at meeting time). Just be aware that the risk-reward trade off right now in the short term doesn't appear all that favorable as long as you assume two things. One, the fed fund futures market accurately gauges what the market is currently pricing into prices. And two, the market will be reacting to interest rate speculation and action in coming weeks.

Book Review: Grande Expectations - A Year in the Life of Starbucks' Stock

Recently I was asked if I would consider reviewing a new book about coffee giant Starbucks (SBUX) entitled Grande Expectations - A Year in the Life of Starbucks' Stock. I am not a shareholder in the company, but I am very familiar with the loyal customer base they have been able to amass over the last fifteen years or so since the company's 1992 IPO. Although I am not a coffee drinker, my mother is among the millions who rarely go a day without visiting the neighborhood Starbucks store.

One of the reasons I agreed to read and review the book is because the performance of Starbucks over the last three years has been a valuable lesson for growth stock investors and I was curious to see what conclusions the author, Karen Blumenthal, would draw based on her research. As you may know, Starbucks shares have been dead money since late 2004 despite the company's continued growth. Even in the face of the chain's 20% annual growth rate, investors have been disappointed in recent years mainly because although growth has been strong, the stock's P/E has been compressing, which more than offset any earnings growth.

Blumenthal essentially devoted a year to following Starbucks. She visited investors (both retail and professional), attended the annual meeting, met with analysts, and spoke directly with the company's management team, all in an effort to find out what kept the Starbucks story ticking and what issues the company and its investors faced every day.

After reading Grande Expectations, it seems to me that there would be three main groups of people who might be intrigued by the work. The first group is the most obvious, Starbucks enthusiasts. The book does a great job of giving readers an inside look at the company's history, how it operates, and what exactly management spends most of their time thinking about. If you want an insider's perspective, Grande Expectations will likely be an enjoyable read.

The book is also being marketed as a investor tool to provide "unique lessons in understanding how the market really works." On this end, I think it is important to distinguish between which type of investor would benefit from the book. I would recommend Grande Expectations for beginner investors who want to learn more about the basics of how the stock market works, how the industry players are related, and how various segments of the investment advisory business (research analysts, retail shareholders, mutual fund managers, etc) play a role in the investment process.

Blumenthal spends a good deal of time talking not about Starbucks specifically, but how, for instance, a research analyst following the company does his/her job, or how a mutual fund manager decides to buy or sell the shares. If you are interested in learning more about these players, in addition to learning about Starbucks specifically, then the book could be valuable.

Aside from Starbucks watchers and novice investors, I don't think experienced investors, professional or individual, would learn a lot from the behind-the-scenes look the book offers. These people, myself included, already know how the industry operates and I found myself skimming through some of the book, including parts like one that explained Reg FD or the supposed wall between investment banking and sell-side research analysts. If you are looking for new insights as to how the pros do their jobs, in hopes that it will enable you to boost your investment returns, I would say that would only be case if you are not already an experienced investor.

Surprisingly (or not surprisingly given the author is a journalist, not an investor) the book really does not focus much on the reason why Starbucks stock has underperformed in recent years (P/E compression). Most of the investors cited in the book admit the P/E is high, but continue to hold or buy the stock because of the company's consistent growth. This logic can be acceptable to an extent, and is the reason why Starbucks deserves an above-market multiple, but paying 40 or 50 times earnings eventually will come back to haunt you. Investors have seen this firsthand during the last three years as shares have moved sideways due to P/E compression completely offsetting earnings growth.

All in all, this book provides excellent insights for novice investors and loyal followers of Starbucks, but falls short in providing extremely valuable investment insights that could not be found in most other investing books already on the market. As a result, I would expect other reviews to be mixed depending on which perspective the reader has on Starbucks stock.

Don't Blindly Follow Carl Icahn (or anyone else for that matter)

From the Associated Press:

BONITA SPRINGS, Fla. (AP) -- Shareholders of WCI Communities Inc. elected billionaire Carl Icahn to the board of the struggling homebuilder on Thursday, more than four months after management rejected his $22-per-share takeover bid. Icahn and WCI clashed for weeks over Icahn's proposed takeover and control of the board, each urging shareholders to support their candidates, before settling recently on the compromise approved Thursday. WCI nominated three of its candidates, plus Icahn and two of his candidates. Three additional directors were nominated jointly by WCI and Icahn. Icahn companies control more than 14.5 percent of WCI.

That's right, Icahn wanted to buy WCI for $22 per share. The stock currently trades at $9. That boneheaded bid lands him a board seat because of his 15% stake in the company. But hey, if I was a shareholder and he bid $22, I'd vote him on the board too.

Seriously though, I bring this up because many investors blindly buy stocks that billionaires like Icahn and Buffett get involved with. Although they make a lot of money, they are human too, so they make mistakes just like the rest of us. As a result, do your homework even if you want to follow a great investor into an investment. If your research yields a strong reason to buy (which would likely not have been the case with WCI) then at least you have less of a chance of making a mistake.

Full Disclosure: No position in WCI

Forget Betting on NFL Games, Wager on Fantasy Performances!

I probably wouldn't have seen this story if I didn't have a merger arbitrage position in Station Casinos (STN), but I'm glad I did. It turns out that Station sports books in Vegas are now going to let you bet on your fantasy football players. Here is the first couple paragraphs of the AP story:

Vegas Sports Book to Take Fantasy Bets

Thursday August 30, 12:33 pm ET

By John Mcfarland, Associated Press Writer

Las Vegas Sports Book to Start Taking Bets on Players' Projected Fantasy Statistics

The billion-dollar business of fantasy football is getting another new player: Las Vegas oddsmakers. Station Casinos Inc., the fifth-largest sports book in the country, was to become the first to release a betting line -- at 7 p.m. EDT -- and start taking wagers based on players' projected fantasy statistics.

So instead of plunking down a bet on whether the Saints will beat the Colts next week, or how many points will be scored, a better in Vegas can wager that Reggie Bush will finish with more than 16 fantasy points. Or that Peyton Manning might be under 21.

I can just see it now. People betting against their own fantasy roster to ensure they win some cash, either from their bets or from winning their fantasy league. It really is a good idea for Station though, as I have no doubt there will be enough people doing this to make it worthwhile for their books.

Full Disclosure: Long shares of Station Casinos until the merger closes

Inventory Levels Suggest Housing Market is Far from a Bottom

There are undoubtedly a bunch of contrarians tying to find a bottom in the housing market, but I don't see any evidence that a rebound is anywhere in sight. The key metric here is home inventories. Without a drawdown in the inventory of unsold homes, prices will not stabilize, let alone begin rising again.

The July report from the National Association of Realtors shows single family home inventories jumping more than 2% year-over-year to nearly 4 million units. Not surprisingly, sales for the month dipped to a five-year low and prices fell 0.6% from last year.

Including condos, inventories soared 5.1% to a record 4.59 million units, putting total inventory at a 9.6 month supply. It's going to take a long, long time to work through that much supply, so don't expect the housing market to stabilize anytime soon.