With most of the P/E ratios at 20 or higher, most of these segments do not
appear to be particularly attractive. However investors may also wish to
consider the expected growth or contraction of the earnings that are driving the
P/E for a particular segment. High growth can support a high P/E and low or
negative growth leads to lower P/E ratios. Also for some industries like mining
and real estate, the GAAP earnings may arguably understate sustainable free cash
flow therefore justifying a higher P/E. For more on this see our articles on
understanding P/E ratios. Possibly,
some segments, which may not have a lot of companies in the sector, like Gold
are affected by one or two companies within the sector having unusual losses.
Overall, the above P/E ratios would suggest a need to be cautious. There
are always bargains to be found among individual stocks, but when the
overall market seems somewhat expensive it obviously bcomes harder to find
the bargains.
INTEREST RATES
In recent weeks, long term interest rates and really started to rise
noticeably, although they are still at levels that are quite low.
The ten-year government bond yield (market interest rate) is now 4.40%,
that is up noticeable from the 3.80% levels reached in the Summer of 2005,
but it's still low considering it was at 4.40% at the end of 2004, and 4.88%
at the end of 2002 and 5.44% at the end of 2001 and much higher than that
through much of the 80's and 90's.
Note that short-term interest rates have increased very sharply over the
past two years or more. But it is only in the last 6 months and particularly
the last 2 months (and most noticeably the last 2 weeks) that
long-term interest rates have really started to rise.
I believe that the impact of higher rates is already being felt in stock
prices for Income Trusts, utilities and other higher-dividend-paying stocks.
In theory, higher long-term interest rates immediately reduce the monetary
value of all assets (including certainly stocks, bonds, and real estate).
However the reduction in value is most immediate and pronounced for assets
that provide fixed future cash flows - and the farther into the future
the cash flow is, the bigger the drop in value with an increase in interest
rates.
Consider a $100,000 bond that pays a market interest rate of say (5%) or
$5000 per year and then returns the principal amount in 10 years. If market
interest rates for this bond rise to 6%, then the value of this bond, will
immediately drop and there are formulas that can tell us the precise amount
of capital loss on this bond.
In contrast the value of stocks is usually based on an estimate of future
earnings. Because of the uncertainties involved there are no precise
formulas to tell us how stocks will react to higher interest rates. But
directionally we know that (all else being equal) they will drop. The stock
price will drop because the value of its future dividends will drop even if
those dividends are unchanged. Furthermore, if the market senses that the
higher interest rates will slow the economy and hurt the earnings of the
company then the stock value could drop even more than a bond would.
Of course some stocks will continue to rise even if interest rates rise.
Stocks with sharply rising future earnings can over-come the gravitational
pull of higher interest rates and keep rising.
The point is that if we expect long-term interest rates to continue to
rise, then this is generally a negative indicator for both stocks and bonds.
For stock investors, in this scenario, it will pay to be selective and look
for stocks that will be less harmed by higher interest rates.
It is not a certainty that long-term interest rates will continue to
rise. Therefore many investors will choose to remain invested in long-term
bonds and the more interest sensitive stocks. Remaining in such investments
can be a rationale strategy for many reasons.
Stock Option Expenses
For many years corporations were not required to expense the value of
stock options. Now they are required to do so. Somewhat surprisingly, this
has not had much impact on earnings.
Some companies have scaled way back on issuing stock options and have
chosen other ways to compensate and motivate executives. Given that many
companies were handing out options like candy (sometimes transferring
obscene amounts wealth from shareholders to executives) this is generally a
good thing.
Sadly, many companies are reporting stock option expenses that are
clearly much lower than the true expense (I would estimate about 10 times
lower in many cases). One reason is that they may show only the expense for
the options that "vest" in a particular year and exclude the expense
associated with options issued this year, that will vest in future years.
That would not be such a bad thing except they also are usually excluding
the vesting of some prior years options that were issued before the
accounting rules changes but which vest this year. But that problem will
fade away once the new rules have been in place for about 6 years.
Another reason for low option expenses is essentially the ability to
choose parameters of the stock option valuation formula which produce
nonsensically low results. Essentially a company can issue options with a
highly valuable life of 10 years but in the valuation can assume that they
will be cashed out in say three years on average. Due to that type of
assumption I have seen companies report values for 10 year options that are
actually below the value of similar options which trade on the market with a
life of under 6 months. 10 year options are worth vastly more than 6 month
options and it is nonsensical for management to use such results. Yet it is
all legal and is blessed by auditors.
There is really nothing that investors can do about this. Even analysts
are not likely to try to adjust the option expense to a higher more
realistic figure. I would only consider worrying about this in cases where
the company seems to be granting excessive amounts of options since in that
case the under-stated expense could be material. Hopefully regulators will
deal with the problem in future.
The Abundance Mentality
Do you operate from the abundance mentality or the scarcity mentality?
The scarcity mentality holds that essentially all things in life are
scarce. For these people, clearly money is scarce and must be guarded and
not shared to any great extent, which frankly most people would agree with
to a very large degree. But also in this mentality things like praise,
trust, kindness and love are scarce. Someone with a lot of this scarcity
mentality would generally not praise a co-worker, particularly in front of
the boss. After all, using up scarce praise on a co-worker might mean that
there is less for the individual. In extreme cases people with too much
scarcity mentality will tend to hoard and withhold time, money, trust,
praise, kindness, love and most everything else from most of the rest of the
world, including possibly their own families.
The abundance mentality in contrast holds that most things in life are
abundant. Certainly praise and kindness and love are for the most part
abundant and indivisible. Giving praise, trust, kindness or love, in the
vast majority of cases will not only diminish the amount of the same that a
person will receive but will in most cases vastly multiply it and these will
be reflected back on the giver. Some people even believe that the abundance
mentality even applies to money, that for example giving to charity will
lead to rewards through good karma. Most people would not agree to go too
far in applying the abundance mentality to money but it may be worth trying
with a certain portion of our funds as budgets allow.
I must admit that I have not held to the abundance mentality as much as I
should. But I think I am getting better at it as time goes on. I am always
impressed by people who display unusual amounts of the abundance mentality
and who for example offer heartfelt and sincere praise on a frequent and
consistent basis. And I have noticed that some of the most successful and
popular people exhibit such an abundance mentality. On reflection, that is
not surprising.
In terms of picking stocks, I have always been turned off by managements
who blame their problems on others, or who disparage their competitors. In
effect that is a form of the scarcity mentality. Companies that acknowledge
(and maybe copy) some of the good things that their competitors are doing
probably have an abundance mentality. Also, too often I have been a bit too
suspicious of the claims made by various companies. Sure there are a lot of
scams out there and we have to careful. Things that look too good to be true
may indeed be. But sometimes we will miss out on excellent companies to
invest in or excellent products to buy because we are overly suspicious and
fail to acknowledge a good thing when we see it. (On that note I will end
and also remind those of you who are not subscribers to our stock research
that you can subscribe now).
END
Shawn Allen
President, InvestorsFriend Inc.