Where Valuations and Technical Support Intersect

By: Chris Ciovacco | Thu, Nov 13, 2008
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"Where observation is concerned, chance favors only the prepared mind."
Louis Pasteur (1822-1895)

The basic fundamental value in buying a stock or a business is the cash flow it can produce over time. Investors discount expected cash flows to a single present value to come up with a valuation for a stock or business. You value a stock the same way you would value a dry cleaning business. A prospective buyer of a dry cleaning establishment wants to know how much cash it can produce over time after all the bills are paid. Discounting the anticipated future cash flows of a business to the present (time value of money) helps you determine what the dry cleaner is worth today (valuation). To make sure you do not overpay for the business, you should discount earnings from both periods of economic expansion and economic contraction. The dry cleaner's profit margin, like most businesses, will be higher in good times and lower during recessions. Using a single year's cash flow or revenue will not paint an accurate picture of the business' true value to an owner.

As an investor, if you feel Johnson & Johnson (JNJ) is going to be around for the foreseeable future, you should evaluate the stock as if you were going to buy the whole business by discounting anticipated cash flows. Stockholders basically own a partial claim to future cash flows. Using this rationale, value investors have the guts to step in and buy good businesses during a bear market (when they are cheap). As bad as things are now, we all know numerous companies will still be producing free cash flow (real profits) for many years to come. Not all public companies are going the way of Bear Stearns. I think it is reasonable to assume that businesses like Coca-Cola, McDonald's, Microsoft, Proctor & Gamble, and Wal-Mart will be viable in five years. Since stocks were trading at inflated valuations for many years, investors still need to evaluate what a claim to the future cash flows is worth. A good stock has relatively stable long-term cash flows at a fair price. Price-earnings ratios (PEs) are used to track the valuations of stocks or stock indexes. A PE ratio tells us how much investors are willing to pay for $1 worth of earnings. When PEs are relatively high, investors are willing to pay more for the earnings/cash flows of businesses. Conversely, when PEs are low, investors are willing to pay much less for future cash flows/earnings.

Every Man Has His Price and Support Level

Odds of success for investors are highest when we have both favorable fundamentals and favorable technicals. From a technical perspective, support is an area or price level on a chart where buyers have previously stepped in to buy and halted a decline in price. Support shows where investors in the past have seen relative value in the price of a security (business) or index (a group of businesses).

Just as in the dry cleaning example above, investors should not evaluate a stock solely on peak (expansion) or trough (recession) earnings since the value of the business is determined by the anticipated long-term future cash flows, which will include good and bad times. To get a better feel for the long-term value of a business, we can use normalized earnings or normalized PE ratios. True value investors care about normalized PE ratios, not PEs based on current earnings or anticipated earnings for two or three quarters. If we discounted Home Depot's anticipated future cash flows for the next year, do you think the present value of four quarters worth of earnings would paint a true picture of the business' long-term value? The normalized earnings for the S&P 500 (used to derive PEs) in the chart below were calculated by John Hussman and explained in Risk Management and Hooke's Law. The chart below shows the normalized PE ratio for the S&P 500 at various levels of technical support. The areas labeled A thru E show potential areas of technical support for the S&P 500 should the market continue to decline. The PE shown for each corresponding level on the S&P 500 (439-840) is based on Hussman's normalized S&P 500 earnings.

On a relative basis, the area with the strongest technical support and reasonable valuation is near 768 on the S&P 500 (labeled B in chart). The S&P 500 closed at 852 on Wednesday (11/12/08). Support at A (840) may hold, but recent technical activity has been questionable. While the market never delivers a perfect anticipated outcome, a good sign would be for stocks to open weak near a support level and maybe even make a new intraday low early in the session. In the afternoon, we would like to see buyers step in and have stocks close in positive territory and above the nearby support level. If the "reversal day" occurs on very heavy trading volume, it would add to its potential significance. Another "follow through" day should come soon after the reversal day. The gains on the follow through day should be significant and also occur on strong volume. Some variation of the scenario described above would give institutional investors additional confidence to buy stocks.

Due to weak and deteriorating fundamentals (serious systemic problems), stocks may plow through both 840 and 768 during future weakness - or they may not. What happens at these support levels will dictate our allocation decisions. We are going to have to stay alert and see how things unfold.

Point C (716) valuations would be even more attractive than point B (768), but the technical support is weaker. Point D (605) offers slightly better hope for support than point C (716). With a normalized PE of 7.08 at point D, the odds are very good attractive long-term valuations would bring buyers off the sidelines. If the S&P 500 does not hold at point D (605), it really might "be different this time." The bear market has the potential to do significantly more damage to buy-and-hold investors if support near 768 does not hold. A break of 768 would most likely bring a significant amount of shorts back into the market.

It is interesting to note that another method used by market technicians also points to potential support at 788 and 602 on the S&P 500. Fibonacci calculations are used to determine typical retracements during market pullbacks. 788 represents a 50% retracement from the S&P 500's October 2007 high of 1,576. 602 would be a 38% retracement.

A Big Picture Look At Our Longer-Term Objectives

 


 

Chris Ciovacco

Author: Chris Ciovacco

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE.

Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. CCM helps individual investors and businesses, large & small; achieve improved investment results via research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions.

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Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
austrian-money-supply/