Investing Wisely -- An Effort for a Rational Valuation of Today's Indices / Marketplace

By: Steve Bauer | Sat, Nov 20, 2010
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Brief Introduction

My focus is "Investing Wisely," e.g. taking advantage of the bull/bear cycles as they occur within the overall marketplace. Integrating modern analytics within these cycles, means maintaining a process of the thorough fundamental analysis of the marketplace as represented by indices such as the S&P 500, 400, and 600 Indexes, etc. This often begins with the old top/down research of these and several other Indices. I believe that this discipline provides the necessary clarity regarding the rotation that most all companies goes through - from favorable times to unfavorable times and perhaps back again.

"The market is doing what it loves to do!" I like that statement (I use it often) is very true, and it does as it wishes both fundamentally and technically. However, what often appears to be a fact is, in reality, quite definitely - very creative fiction. The fictional stories being told by Wall Street and the media are so compelling that the public investor takes the hook, every time. That's sad and expensive.


The Marketplace

At least weekly, and frequently more often I go through a process that profiles the marketplace. Actually, I do this for all my "subsets" - primary sectors, sectors, current favorite industry groups, commodities and country ETFs. Within this process, I am seeking to identify where these components are - within their economic, fundamental and technical cycle. Call this, if you like, a metric that I use for my "conformations." Conformations are how I decide on the "when" to take a bullish or bearish position - identifying tops and bottoms, if you will. It includes a lot of "stuff" including a balance of the old risk/reward formula.

Over the past few weeks there has clearly been an internal market deterioration that is setting up for a meaningful pullback.

Most recently the currency problems, weakness in Irish, Greek and Spanish debt, a plunge in municipal bonds, Chinese's problems and more have been in the news. I'm not much on the "news" per se, and dislike the presentation methods of the media big time. So for me, much of this is discounted in favor of my fundamental analysis (valuations) and the price/cycle movement of the above indices and "subsets." It should be clear to all that all securities and indexes will change as market conditions (political, economic and financial) evolve over time.


Fundamental Valuation / Analytics

Since coming out of retirement in October 2007, and re-entering the realm of earnings and cash flow analytics, I have witnessed a vast change in "valuation" practices. Oh, the shenanigans and other games were going on before, but it has developed into a finely honed science. Many of those who are supposed to be analysts are providing future estimated operating earnings, as if they are really actual values today. They definitely are NOT and this has bothered me greatly. The marketplace clearly "wants to be told -- all is ok" so that is what is being given by professional financial analysts and the media. That is at the expense of a lost word in our present financial reporting - it is called "integrity." I fear both leadership and integrity are lost forever. So, I just compensate (do a bit of "tweaking") and thus am able stay ahead of the game.

In the recent past weeks of "earnings season", the arguments are even more compelling and the numbers even more unrealistic. Statements are being made that "stocks are cheaper" than in February 2009." That is the ratio of the S&P 500 to the current forward operating earnings' estimate. Analysts have clearly created new methods for calculating valuations, just as if, we were currently at historic lows going back to 10 or even 20 years ago. Impossible but true. I suggest that you start taking account of these practices and understand that much of this "new/funny math" is almost worthless data. This is not sound valuation work and little more than random guessing.

So for me and perhaps for you, the question is: Can there still be a way that forward operating earnings (FOE) be employed as a useful measure of market valuation? The answer is actually and remarkable - yes. The data is still there and the formulas of old fashioned "real math" still work. However, if "they" are going to be "creative" so will I, in a much different manner. I have recently used the word "tweaking" the numbers in my articles. What I mean is adjusting valuations back to reality.

This can be done with the help of studying price movement and regression analysis, which is not necessarily what I would call "technical analysis." Through comparative analytics the price movement can be accurately correlated with future estimated operating earnings. As an old guy, with a bit of fox still left in me, I find this to be fun and this work has produced some very accurate forecasting.

I suggest that the below chart is well worth your time for a brief study. It should at least cause the bulls to pause, at least for a minute or two.

S&P500 versus 12-month Forward Earnings Estimates

Notes for chart:
Saying it nicely, revisions to analyst earnings projections only require a little more work/analytics to get it right. Once completed you have one of the best leading indicators to provide a path to inflections points for the general stock market, sectors, industry groups, and their component companies.

You will note in this chart that the 12-month forward S&P 500 earnings estimates peaked at $103.61 per share right when the market peaked in October 2007. It bottomed, in March 2009 at $60.08.

The consensus analyst earnings estimates on a 12-month forward basis peaked this year in April, again in phase with the S&P 500 at $94.79. It has since declined for five months in a row and so far in September is down 1.3%, to $86.74.

So you may say that it missed the September rally, and you would be right. Except, for "new/funny math." Think about that...


My Current Market Valuation

Just for clarity, "valuation" is a fundamental process of analysis of earnings, cash flow and other quantitative work. The market's indices remains over-extended, hyper and ready to disappoint. There is an Internal consolidation of future earnings that is not a precise indicator. This is not easy to detect or calculate. However, it is an excellent leading (anticipatory) indicator. The current "choppy" topping process of the Indices themselves is characteristic with past examples. Those examples are ancient history except for last April's highs. This past April the indices took over six weeks to finally top.

The concern that should be on your mind and is definitely on my mine, is that one or two days of declines can seriously erode profits you may have accumulated over a long time frame. The current market environment is one of very real "caution."

Mathematically, the fair value of the S&P 500 Index depends on the return that investors require, the current earnings level, the expected growth in earnings, and the probable Price/Earnings ratio, that it can be expected to be sold for, at the end of a reasonable holding period.

That said, I continue to believe that the fair value for the S&P 500 is about 1125. I use this number as a "mean" with positive and negative regression points. If then my valuations say that there is an 8%-10% expected upside return, this takes the upper range (positive regression) to about 1230-1250. Low range (negative regression) might be about 6%-7% or about 1030-1040. So my valuation estimates (regressions) are in place and require only occasional adjustments.

My current forecast (adjusted) for the upper range of the S&P 500 is less than the above 1230-1250 and may well be at or around 1210. My current forecast for the lower range of the S&P 500 is also less than the above 1030-1040 and may well be less than the June lows of 1022.

The next set of quarterly earnings numbers become available in late November.


My Technical Thoughts / Analytics

The general market, sectors and many companies are obviously on a tear, except for the pullback of the past couple of days. The "tear" and this most recent pullback, like all such things - will come to an end. So for the marketplace, it is too late to buy and too early to sell. I have sold everything in anticipation of taking short positions in companies and long positions in inverse ETFs.

I remain 100% in cash and am waiting for a Bearish Inflection point to take new positions. That may occur in a couple of weeks or perhaps sooner. The internal topping action is continuing. However, this past week was on balance very positive. That's good if you are forecasting a near-term top. So for this old bearish fox (technically speaking) I'm pleased with the statistics, indicators and charts.

For a current (up to the minute) chart of my five favorite market indices, 12 sectors and 23 high profile companies click and then scroll down.
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID4095527

Should you be seeking near-term or perhaps longer-term market guidance / direction, please feel free to Email me, and I will respond promptly.


My Wrap

It is important that this article not be viewed as a recommendation for the purchase or short sale of any company or ETF at this time. Favorable to the process of "investing wisely," it is intended to suggest that most indices such as the S&P 500, 400 and 600 Indexes, etc. are just an excellent "bellwether" to help identify inflection points as the marketplace cycles from bull to bear and back again over and over and over again.

It is this continuous "cycling" that presents us all with clear inflections points. So the good news is that - we are given frequent and conservative (low risk) opportunities to "invest wisely" or to simple hold cash.



My Current Bottom Line:

* I am holding 100% Cash.

* Patience and Discipline - waiting for my list of Fundamental, Consensus and Technical - "Conformations" to all fall into place is part of the necessary process for "Investing Wisely".

* Inflection Points historically have occurred historically about three - five times per annum. We have already had 5 clear and meaningful Inflection Points so far this year. Investing at or around the time of my Inflection Points has proven to be a profitable way to invest.

* In my late August posting, I said: "The Market is now (very possible) setting up for another meaningful but likely (short in duration) Rally!" It certainly did rally!

* Now it looks just the opposite. One of these days this choppy and bifurcated market (late April to date) will do something meaningful and the next possibility of that is a meaningful Pullback.

* High Volatility may not currently be showing up on VIX - lately, but it is clearly - alive and well.


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Thank you for your time in reading my "stuff" and continued interest in my work.

Smile, have Fun - "Investing Wisely",

 


 

Steve Bauer

Author: Steve Bauer

Steven H. Bauer, Ph.D.

Steve Bauer

Steve has several degrees, i.e. post graduate degrees and doctorate and a great deal of (too much) continued education. For seven years, he did a stent as a University Professor of Finance and Economics.

Dr. Bauer also writes for SeekingAlpha.com. His articles can be viewed at: http://seekingalpha.com/author/steven-bauer?source=search_general&s=steven-bauer

He owned a privately held asset management firm and managed individual investor and corporate accounts as a Registered Investment Advisor - for over 40 years.

Professionally he is a financial analyst and private asset manager / consultant / mentor.

Steve can be reached at senorstevedrmx@yahoo.com

Copyright © 2010-2013 Steven H. Bauer, Ph.D.

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