Tag Archives: time

Declining Housing Starts Equals Big Profits

Since peaking at 2,111 on April 20, 2016, the S&P 500 has rolled over. The broad market index now sits at 2,050 – nearly 3% lower in just a couple of weeks. The S&P 500 chart below has a distinctly negative look to it. Click to enlarge As the S&P 500 peaked, the moving average convergence divergence (MACD) momentum indicator showed significant negative divergence. This is a strong warning sign that the current rally is exhibiting exhaustion and could be vulnerable to a reversal. The S&P is well-below its 9-day exponential moving average (EMA) of 2,068, which means the market could test its 50-day moving average at 2,035. But given recent negative readings on a host of economic reports here and around the globe, there’s a real possibility that a much deeper move is in the cards. And should the market pass through the 2,035 level, there is no real support until roughly 1,980. That’s another 3.4% from current levels. For this reason, traders should use any strength in the market to unload long positions, while also adding short positions. One possible short position is the S&P Homebuilders Fund (NYSE: XHB ) You see, the homebuilding sector is vulnerable here to a sharp pullback. Below is a chart of XHB… Click to enlarge This chart looks eerily similar to the S&P 500 chart. It shows that XHB has also fallen below its 9-day EMA, while also sitting at its 50-day moving average. This means the $34 level effectively becomes XHB’s new level of resistance. This provides an excellent opportunity to short XHB. With the close proximity to the new resistance level at $34, we can quickly exit the position if resistance with a small loss if resistance breaks. On the other hand, if the nine-day resistance holds, XHB should fall to one of the lower support lines at about $31.20 or as low as $30.20. Now, we hold that the $30.20 price target best aligns with our expectation of a moderate pullback (~3.4%) in the S&P 500. This make $30.20 a reasonable target over the next few weeks. XHB closed at $33.29 today. Now, by taking a short position at this level, we’re risking $0.54 per share if the stock moves higher. Conversely, we stand to pocket $3.00 per share if we’re right and XHB moves lower. That gives us a good risk/reward setup. But we can mitigate our risk even further by purchasing put options on XHB instead of shorting the stock. Here’s how… Let’s assume you’d typically short 500 shares of a recommended stock. At today’s price of $33.29, you’d pony up about $16,650 to short the shares. Now, most investors are willing to absorb a 10% drawdown on shorted stocks should the stock run the wrong direction. This would limit your loss to $1,665 before you exited the position. But, because $1,665 is the most you’re willing to risk, you could instead use the $1,650 to buy the puts. But let’s reduce our risk even further by cutting our maximum loss in half… The XHB June $34 puts closed Thursday at $1.15. With $825, you can purchase seven put options on XHB. Since each option contract covers 100 shares, that gives you control of 700 shares of XHB – versus the 500 shares you would have shorted with the $16,665. You’ve reduced the risk on this trade, while also increasing the potential reward by controlling more shares. This is the right way to speculate with puts. Of course, if we’re wrong on this trade, you could lose 100% of the money you used to buy the puts. But it’s far better to lose 100% of $825 than to lose 10% of $16,665. And if we’re right on this trade, you can make more money by owning seven puts than by shorting 500 shares. So, by purchasing puts instead of shorting the shares, we reduce our risk and increase our potential reward. It makes for a more intelligent trade for managing risk/reward. Here’s the trade in a nutshell… Buy the XHB June $34 put options (XHB160610P0003400) up to $1.25. This option closed yesterday at $1.15 when XHB closed around $33.29 per share. You should be able to get into this trade as long as XHB is trading above $33.30 per share by the time you enter your order. If the stock falls and the option moves out of range, or if the option spikes higher as a result of this recommendation, give the trade a day or two to come back into range. Going forward, if XHB falls to our downside target at $30.20 per share, the June $34 puts will be worth at least $3. That’s a 161% gain on the trade. Once the options have double in price, sell half the position. This will eliminate any chance of a losing trade. Then focus on maximizing profits if XHB moves lower. One caveat…. It’s important to remember this is a speculative trade. We’re buying short-term options in anticipation of a stock market pullback. There’s no guarantee the market will fall or that XHB will decline even if the broader market falls. You can lose everything you put into this trade. So, please, limit your risk to less than half of what you would normally be willing to lose on the stock. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

What’s In A Multiple?

What’s a company worth? Seasoned investors know that finding the answer to that question is more art than science. One way to do so is from the bottom up, to calculate a firm’s intrinsic value using a discounted cash flow methodology. The other is to come at the question from the top down, by using a relative valuation approach via market multiples. While there are many types of multiples, each reflects the market’s evaluation of a company’s expected operational performance, and can be used to cut across times, sectors, and markets. Investor expectations about future revenue growth and profitability both play a key role in driving multiples. Investors obviously prefer high levels of both. But if there’s only one to be had, which combination do investors value more highly? Superior growth and low profitability? Or lower growth and high profitability? Credit Suisse recently analyzed the performance and multiples of companies with market capitalizations of more than $1 billion (excluding financial firms and utilities) between 2004 and 2015, to find out. Not surprisingly, the bank found that companies with above-median projected growth in revenue and above-median projected profitability traded at an 11.5x EV/EBITDA multiple, compared to just 7.5x for firms with below-median estimates for future revenue growth and profitability. (For reference, the median projected revenue growth was 5.4 percent and the median profitability was 6.5 percent cash flow return on investment.) But back to the question of revenue growth versus profitability. It turns out that firms with below-median forecasted growth but above-median projected profitability earned higher EV/EBITDA multiples (10.2x) than faster-growing but less profitable companies (8.7x). Furthermore, increases in expected profitability had more of an effect on valuations than did an increase in expected sales. Regardless of whether a company is expected to grow above or below the market median, if it manages to improve profitability above median levels, the effect is dramatic – an additional 2.7 times enterprise value relative to the company’s forward cash flows. That was more than twice the effect that improving revenue growth – an additional 1.2 times EV/EBITDA – awarded to those companies that managed to climb into above-median revenue growth territory. Those that were able to vault over the median in both categories saw multiples rise by 4x EV/EBITDA. In short, growth matters more when you combined it with superior return on capital. Source: Credit Suisse HOLT Corporate Advisory It’s interesting to note that the current preference for profitability over growth is a relatively recent phenomenon. Between 2004 and 2007, companies with above-average revenue growth expectations traded at higher valuations than those with high profit expectations. During the financial crisis, there was no clear pattern to investor preferences, but high-profitability companies began to deliver higher premiums in 2012. One possible rationale for the shift: Over the past decade, it’s been easier to keep returns on capital up than to produce drastic increases in sales. Fewer than one-third (29 percent) of companies that produced above-average revenue growth between 2004 and 2009 did the same between 2010 and 2015, while nearly two-thirds (64 percent) of companies that were highly profitable in the first five-year period remained so in the second. Investors, in other words, can be fickle. So how should that affect executive decision-making? For executives making resource allocation decisions, it’s clear that both profitability and growth matter. But understanding exactly what drives investor sentiment about a company is important not only in choosing between competing strategies – those promising faster growth or superior profitability (or, in an ideal world, both) – but also what to buy and how to buy it. Knowing how expectations of future growth and profitability drive valuations can help companies decide on the right price to pay for potential targets as well as secondary decisions, such as whether equity or cash purchases make more sense. In other words, multiples matter for more than just bragging rights. Original Post

Using Economic Indicators To Time The Market

If you pay attention to the financial market news, you may have noticed a lot of attention being focused on the slowing US/Global economy and the implications it has for financial markets. Just do a search on ‘slowing global PMI’ and watch the hours waste away. Basically, the US/Global economy is slowing which means recession is right around the corner, which means financial markets will tank. That seems to be the predominant bear case now, or one of the many. There is some merit to this argument. The worst market downturns occur during recessions. The trick is that you need to know that before the recessions actually happen. In this post, I’ll point you to some research in this area, then focus on just one indicator that does a decent job of forecasting recessions and how it can potentially be used as a market timing indicator on its own. To try and predict recessions, there are all kinds of metric and techniques used (ECRI, Conference board indicators, etc.). You can spend many many hours looking at all of these and their histories. Believe me. Me and an investor friend have spent tons of hours looking at and studying these. And the history of indicators predicting recessions is mixed to say the least. But I won’t bore you with that here. Instead, if you’re interested, you should read this by Philosophical Economics (which I’ll call PhiloEcon) and some of the linked posts in that piece. There is some incredible work and insight in the post (pretty much anything he/she writes is worth your time). Turns out that historically, the change in the trend in unemployment rate has been a pretty good indicator of recessions. It has also been decent at signaling when the economy has come out of a recession. Below is the key chart. Not bad. When the unemployment rate crosses above the 12-month moving average to the upside, a recession is likely coming, when it crosses below the 12-month moving average, the economy is out of the recession. Can this be used to time the stock market? And does it work better than other market timing indicator such as the popular 200-day simple moving average of prices? Basically, yes. You can read through the post and see how using the unemployment rate improves returns and risk over buy and hold and a trend following system. As usual, I wanted to run some numbers myself. Let’s take a look at that. I first wanted to see how the unemployment rate indicator (UI from now on) performed on its own versus buy and hold and other trend indicators, specifically the 200-day SMA and 12-month absolute returns. I also wanted to use real investable products, including fees. I looked at returns going back to the beginning of 1999 through April 26, 2016, for the S&P 500 ETF (NYSEARCA: SPY ), which fortunately started in 1993. This time period encompasses two of the biggest market downturns in history. I compared buy and holding the SPY versus using the 200-day SMA, 12-month total return, and the UI to exit and enter the market. When the timing systems are out of the market they are not invested, i.e. 0% cash return. Below are the results. Very impressive. This simple indicator delivered returns 3.4% per year greater than buy and hold and more than doubled risk-adjusted returns. It also beat both other timing systems by a long shot. In addition, the simple UI system produced fewer false positives and traded a lot less. Definitely worthy of consideration. You can probably see where I’ll be going next with this. In some following posts, I’ll look at adding a risk-free asset to the mix during times of risk-off, combining the UI with other indicators (which is what PhiloEcon has done in the GTT system), and adding some global risk assets to the mix. To give you a preview, they are all better than what I’ve shown here. Finally, before I end this post, what is the unemployment indicator saying right now. Does it support the bear case I noted in the opening paragraph. No, it doesn’t. The current unemployment rate is 5.0% where the 12-month moving average stands at 5.2%. If the unemployment rate increases by 0.1% each of the next two months (April and May – remember the reported unemployment rate is for the previous month), then the rate would cross above the 12-month moving average. We won’t find out until the May unemployment rate is reported at the beginning of June. And we’ll know this week what the April rate is. This seems unlikely but you never know. The FOMC’s own projections don’t support a change but they are notoriously poor forecasters. Others think that more realistically the end of the year would be the time frame we could possibly see a trigger. But there is no need to forecast to use the UI system. For now, if you were using this system it would be risk on still. In summary, historically, the change of trend in the unemployment rate has been a good signal to time the market. Better than the two most popular trend indicators around.