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Valuation Challenges When PEs Are Expanding: 2 Examples

One hallmark of this secular bull market is expanding PE/cash flow multiples. Thus valuations based upon recent historical multiples can be deceiving. I give an example from one stock and one broad ETF. Everyone knows we have been in a cyclical bull market since the spring of 2009. I have argued elsewhere we are now in the early stages of a secular bull market that should continue well into the next decade. One argument supporting this view is to point out that the PE compression which characterized the earlier years of the 21st century has ceased. I shall illustrate this with a few charts shortly. Why is this important to investors? Many analysts judge the attractiveness of the market or a particular stock by comparing PE multiples (or cash flow multiples) with traditional and recent (say, the past decade) multiples. A stock selling at 45x earnings when historically it commanded a multiple closer to 18x is likely to be overvalued and less attractive as an investment or source of dividend income. If we are in a period of rising multiples, however, comparing current PEs to those of the past few years may make companies appear overvalued, when in fact they remain attractive investments going into a brighter future. We can use Teleflex (NYSE: TFX ) as an example. The Value Line chart below shows that TFX traditionally has commanded a cash flow multiple of 10.5x. Well above this (e.g. 2007) was an attractive time to sell, below it (e.g. 2003 and certainly 2009) were great entry points. What should we make of the current multiple, which is closer to 20x cash flow? (click to enlarge) source: Value Line The quick conclusion is that TFX is overvalued and buyers should not pull the trigger. But what if we are in a period of rising multiples, for reasons i made clear yesterday ( here )? This is even more likely given that medical technology is an emerging super field and has been a market leader for several years now. Combining fundamental analysis with charts and some technical snooping might shed more light, and useful trading information, on this challenge. The chart below shows that TFX has been in a bull market since 2009 and ascending in a broad channel as shown in white. If you look at the white channel, TFX touched the upper boundary (it was “overvalued”) in April of this year. But instead of selling off and churning like it did for almost two years back in 2010, the shares have worked their way higher. Maybe we should assume the price range is better defined by the red channel now. Oddly enough, that also suggests it is now fully valued. But the point where a prospective buyer might want to reacquire the shares is quite different. If the higher evaluation (red channel) mode is now in force, that price is approaching $100 as the new year unfolds. Using the old valuation channel, a buyer wouldn’t be interested until the price falls well into the $70s. This might be mere curve fitting but for the fact that broad indexes and ETFs such as the S&P500 Trust (NYSEARCA: SPY ) show almost exactly the same phenomenon. Compare the white and red channels in SPY below. (click to enlarge) source: freestockcharts.com Is this new channel reflective of higher valuations? Yes: (click to enlarge) source: etrade . While some expansion might have occurred in the early years of the bull market because earnings (the denominator in PE) are lagging indicators, it certainly is not the case now: corporate earnings growth is strong. And likely to get stronger! Already third quarter GDP growth came in at 5%, and second quarter GDP was revised higher. The full effect of lower oil prices still has to fully work into the economy, and the fiscal prudence of a Republican House (and now Senate) seems destined to continue. While it may be an ad hoc/seat of the pants process, investors would be well advised to revise their tolerable PE/cash flow multiples on stocks higher in the next few years. Get ready to buy Teleflex shares if a correction brings prices back to the high nineties.

Why I’m Margin SHY

Summary Margin interest rates at major brokers are several percent. One could instead short SHY at the cost of one half a percent. Tail-risk could make this dangerous. ETF Description SHY is the short-duration treasury ETF managed by iShares. It holds treasuries with a duration between 1 and 3 years. It currently yields 0.46%. It effectively mirrors the behavior of the two year yield. SHY data by YCharts Thesis Below is a table taken from Tradeking of current margin rates at major brokers: One could save substantially by instead shorting SHY. For a hypothetical portfolio which has two dollars of equity for each dollar of margin the current interest charge might be 8%. By lowering that to 0.5% by shorting $1 of SHY for each two dollars of equity, our hypothetical portfolio would perform 3.75% better (on equity). Maintaining this level of out-performance would result in having twice as much money over twenty years! One may also benefit from capital gains because short term yields seem, on balance, more likely to rise than fall over the next ten years or so. Investment Risks Is this a free lunch? I’m honestly not quite certain. On May 6th, 2010 the Dow Jones Industrial average dropped 9% and recovered over the course of minutes. Some stocks, like Procter & Gamble, traded down to a penny. If for some reason there was a flash spike in the value of SHY and your broker forced liquidation, you could be wiped out. It’s hard to quantify the likelihood of such a situation. This is in general a problem of using margin, as a flash crash could wipe you out if your broker forced you to sell at pennies. One might be inclined to think that the risk could be decreased by using multiple short-duration treasury ETFs. This is not the case. It simply adds more danger, because any one of them could theoretically trade at an insane level. The fact that each ETF would represent a smaller amount of money doesn’t help, because it only takes one share trading for $100,000 (as some stocks did during the flash crash) to wipe you out. An important question to ask your broker is what they would do in such a situation. Second, if short-term yields declined further the value of SHY could increase. Suppose that short term interest rates went to negative 3% overnight. If the average duration is roughly two years so if the ETF reflects net asset value the value should increase to something like 6% above par. This would translate to a 6% increase in the ETF’s value. This might be scary if it happens overnight but isn’t much larger than you might have paid for interest over the course of the year. Much larger negative interest rates could cause more significant losses. If we saw short term interest rates go to negative 30% the Net Asset Value of the fund would double. If your broker forces you to sell at that point your losses could be substantial. Third, a deflationary environment might cause a similar problem. The value of short term treasuries might spike. To get a substantial loss (eg. 50%) we’d still need to see something like 17% deflation or 17% negative interest rates. Fourth, if your stock portfolio drops in value you might be forced to sell some positions at depressed values to cover your short position. This is more likely than when using margin! Take the time to calculate how much margin or short SHY you should use under different scenarios. You should at least assume that at some point the US stock market will fall 50%. If it does what will happen to your portfolio? If you are using one dollar of margin per dollar of equity then you are wiped out. Similarly, if you are short one dollar of SHY per dollar of equity you are also wiped out. You might be inclined at this point to say, well alright, I’ll just make sure that my margin/SHY is 49% of the value of my stocks. If this happens, your broker is still likely to force a sale at depressed levels, which could leave you with as little as 2% of your original portfolio value. You need to check what the maintenance requirement for margin is with your broker. For example, at Tradeking the maintenance requirement for stocks above $6 is 30% of the current value. After the drawdown you need to end up with at least 30% equity in your account. This means that you could only have started with a ratio of $2 of equity against $1 of margin to avoid a margin call. Any more margin than this is very risky and over long periods will likely wipe you out. If we handle this instead by shorting SHY the calculation is a little different. The amount of equity can’t (in the case of Tradeking) go below 140% of the market value of SHY. This means that we can only use $1 of shorted SHY for every $4 of equity. Even if you don’t intend to own stocks on margin, but instead use the shorted SHY for something else, you still need to pay attention to this rule. (click to enlarge) I don’t own any stocks on margin, but I am shorting a small amount of SHY to take advantage of a 3% interest rate on a checking account. The maximum amount that I feel comfortable using is 20% of the total stock value of the account.

Crude Oil Price Prospects As Seen By Market-Makers

Summary Oil-price ETFs provide a quick look at expectations for change prospects in Crude Oil commodity prices. Market-maker hedging in these ETFs provide an overlay in terms of their impressions of likely big-money client influences on Oil-based ETF prices. But is there a broader story in price expectations for natural gas? And for ETFs in NatGas, following the same line of reasoning? Change is coming, so is Christmas But in what year? Expert oil industry analyst Richard Zeits in his recent article points out how long prior crude oil price recovery cycles have taken, with knowledgeable perspectives as to why. Still, there is also a suggestion that differences could exist in the present situation. Past cruise-ship price experiences of Crude Oil investors on their VLCC-type vessels have marveled at how long it takes to “change course and speed” in an industry so huge, complex, and geographically pervasive. To expect the navigating agility of an America’s Cup racer is wholly unrealistic. Yet some large part of the industry’s present supply-demand imbalance is being laid at the well-pad of new technology and aggressive new players in the game. In an effort to explore the daisy chain of anticipations that may ultimately be reflected by a persistent directional change in the obvious scorecard of COMEX/ICE market quotes, let’s step back a few paces from the supply~demand balance of commercial spot-market commodity transactions to the futures markets on which are based ETF securities whose prospects for price change attract investors in such volume that ETF markets require help from professional market-makers to commit firm capital to temporary at-risk positions that provide the buyer~seller balance permitting those transactions to take place. But that happens only after the market pros protect their risked capital with hedges in the derivative markets of futures and options, which doing so, quite likely provide some much lesser fine-tuning back into the price contemplations back up the ladder that brought us down to this level of minutia. So where to start? Mr. Zeits regularly asserts that his analyses are not investment recommendations, so securities prices are typically unmentioned, and left to the reader’s cogitation. We will start at the other end, where you can be assured that our thinking is in strong agreement with Mr.Z at his end. We convert (by unchanging, logical systemic means, established well over a decade ago) the market-makers [MMs] hedging actions into explicit price ranges that reflect their willingness to buy price protection than to have their perpetual adversaries in (and of) the marketplace take their capital (perhaps more brutally) from them. Using Richard Z’s list of Oil ETFs, here is a current picture of what the MM’s hedging actions now indicate are the upside price changes possible in the next few (3-4) months that could hurt them if their capital was in short positions. The complement to that, price change possibilities to the downside, could be a yin to the upside move’s yang, but we have found better guidance for the long-position investor’s concern in the actual worst-case price drawdowns during subsequent comparable holding periods to the upside prospects. So this map presents the upside gain potentials on the horizontal scale in the green area at the bottom, with the typical actual downside risk exposure experiences on the vertical red risk scale on the left. The intersection of the two locates the numbered ETFs listed in the blue field. (used with permission) Here’s the cast of characters: [1] is United States Brent Oil ETF (NYSEARCA: BNO ) and PowerShares DB Oil ETF (NYSEARCA: DBO ); [2] is ProShares Ultra Bloomberg Crude Oil ETF (NYSEARCA: UCO ); [3] is United States Short Oil ETF (NYSEARCA: DNO ); [4] is United States 12 month Oil ETF (NYSEARCA: USL ); [5] is ProShares Ultra Short Bloomberg Crude Oil ETF (NYSEARCA: SCO ); and [6] is the iPath S&P GSCI Crude Oil Price Index ETN (NYSEARCA: OIL ). Here is how they differ from one another: All are ETFs except for OIL, an ET Note with trivially higher credit risk and possible slight ultimate transaction problems. All except BNO are based on West Texas Intermediate [wti] crude oil availability and product specs, BNO is based on Brent (North Sea oil) quotes, directly influenced by ex-USA supply and demand balances. Most prices are at spot or most immediate futures price quotes, but USL is an average of the nearest-in-time 12 months futures quotes. All are long-posture investments except for SCO and DNO which are of inverse [short] structure. Both UCO and SCO are structured to have ETF movements daily of 2x the long or short equivalent unleveraged ETFs. What is the Reward~Risk map telling us? For conventional long-position investors, items down and to the right in the green area are attractive, to the extent that their 5 to 1 or better tradeoffs of upside potentials to bad experiences (after similar forecasts) are competitive to alternative choices. The closer any subject is to the lower-left home-plate of zero risk, zero return, the less attractive it is to those not traumatized by bunker mentality. SCO, the 2x leveraged short of WTI crude has a +20% upside with a -16% price drawdown average experience with similar forecasts in the past 5 years. It is a slightly better reward than a bet on a long position in Brent Crude and DNO, whose +18% upside is coupled with only -2% drawdowns. SCO’s minor return advantage over DNO comes largely from its leverage which is responsible for its large risk exposure. The same is true for UCO. USL’s trade-off risk advantage over OIL comes largely from smaller volatility in the 12-month average of futures prices that it tracks, rather than only the “front” or near expiration month. Here are the historical details and the current forecasts behind the map. The layout is in the format used daily in our topTen analysis of our 2,000+ ranked population of stocks and ETFs. For further explanation, check blockdesk.com . (click to enlarge) Conclusion In general, this map suggests that we still have ahead of us some further price declines as crude oil equity investors (via ETFs) see advantages in short structures. The spread between WTI crude price and Brent crude may be as narrow now as is likely in the next few months, given BNO’s relative attractiveness here. This analysis will be followed shortly by a parallel on those ETFs focused on Natural Gas and alternative energy fuels.