Price Earnings Ratio

Price = earnings times average p/e ratio

Personally, I would never consider buying stocks in a company simply based on the recommendation of someone else.  Still, I get questions from friends about buying this stock, or that, based on a phone call they received from some "well-intentioned advisor".  Usually the story is pretty compelling, and there is always a sense of urgency to get in before it is too late.

While I struggle to comprehend the value provided by sell-side analysts, I suppose their value is not lost on firms trying to engineer the case for buying the next hot stock.

There is one piece of information those analysts provide which I do use.  It is the annual earnings number.  These people know and follow their companies better than I ever could.  They crunch the numbers and come up with an estimate for company earnings for the end of the next year.  I don't rely on any one estimate, but I do look at the average of all of the estimates for a company.

For that reason alone, if a company does not have an analyst following it, I won't buy it.  I am only interested in owning companies with a long enough track record and sufficient size to have analyst coverage.  How else can we put any probability on what the company is going to do in the future?  How many times have I seen people lose money in the stock of companies that never made a single cent?  Never mind the hype and the hyperbole, show me the money!

Did you pay full price for the vehicle you are currently driving?  If so, why?  They want our business, and will make concessions to get it.  Do you buy groceries and pay full price when you know there is a sale coming up for the same items, or a coupon which is good at a future date?  Why should we purchase any stock unless it is on sale?

Any company I would be interested in, has to have a track record, have a couple of analysts covering it, and it has to have made money for, at least, a few years.  I have no desire to own penny stocks, or hopeful wannabe's.  The companies I want to own have a great, if not the best track record in their market.  Since I know the future earnings numbers and I also have historical price to earnings ratios, I can calculate what the price of a single stock is worth.  Earnings per share multiplied by the historical average for the price/earnings ratio equals what the stock is worth.  If that is the current price, why would I buy it?  The lower the current price is below the result of my little calculation, the more interested I become.

Don't take the recommendations of other people, especially those trying to sell something.  We need to do our own homework, and calculate what the stock is worth.  Myself, I still wouldn't run to the computer and buy it without, first, doing some technical analysis to figure out a good point in time to buy.  Regardless, unless it is on sale, I won't even consider it.       

Producing Ethanol

It can be interesting how, once information makes its way onto the internet, it can be perpetuated long after new information contradicts it.  I recently read how forty percent of the corn crop grown in the U.S. is being used in the production of ethanol (google: "40 percent of corn used in ethanol").  As a result, there is concern about corn prices, and even wheat prices being forced higher.

When I researched further, I found it interesting to find how little of what I had been led to believe in the past was true.

Myth Number 1:  The use of corn to make ethanol is driving up the price of grains.
Prices may be up, but it isn't necessarily because corn is being used to make ethanol instead of being used as feed.  Corn is mostly used as animal feed, and the corn that is used to make ethanol can still be added to feed.

Myth Number 2:  It takes more energy to make ethanol than ethanol produces.
According to calculations using modern farming procedures and modern production techniques, it is currently estimated that ethanol contains at least 30 percent more energy than it takes to make it.

Myth Number 3:  Using all of the farmland in the U.S. to produce corn for ethanol would only meet 4 percent of the energy needs of that country.
Ethanol burns cleaner and is therefore better for the environment.  The carbon dioxide that is given off in the fermentation process can be captured and used, or stored instead of being released into the atmosphere as when burning hydrocarbons.  Any reduction in green house gases should be seen as good.  We spend money on wind and solar.  They will never meet the total energy needs of the U.S..  Does that mean we shouldn't bother?

Myth Number 4:  Corn grown to produce ethanol is ruining the farm land and wasting water.
That is like blaming nuclear power plants for nuclear bombs.  The real problem lies in proper farming practices, not in the type of crop being grown.  It is okay to grow corn for feed, but it is not okay to grow corn to produce ethanol and then use the corn for feed.  Why?

Myth Number 5:  The high price of corn (because of ethanol) is driving up the price of meat.
As stated before, the more corn that is grown for ethanol production, the more of it is available for feed.  How does that increase food costs?

Myth Number 6:  Ethanol production is only viable because it is subsidised.
With corn at $3.00 a bushel, it is believed to be competitive when oil is at $70.00, or more, a barrel.  The price of corn has risen to twice that recently.  How much should we expect to pay for a barrel of oil in another year?  Two years?

All in all, I am sure the production of ethanol is having some affect on corn prices, but to say the current price of food is because of ethanol is, in my opinion, irresponsible.  Then there is the question of whether it is a good idea to subsidise the production of crops for energy.  We subsidise other forms of alternative energy, why is this example such a particularly bad one?  If we really want to be efficient in our land use, we should stop growing corn for feed, eat less meat, and grow more human food.  Why don't we do that?

Rather than debate the real facts, we end up with a whole lot of misinformation for, and against.  This is exactly what I warn against when trying to decide where to put your money in the stock market.  Identify the relevant data, verify it, check for hidden agendas, and don't listen to all of the unsubstantiated double talk.  By knowing what to look for we can avoid a huge amount of irrelevant, and misleading "noise" and focus, instead, on the important facts that can give us a real return on our money.

Was it only me?  Had you heard of any of these myths about ethanol?

February Portfolio Update

Year To Date Returns

Despite having taken my gains from the decline in gold stocks, I gave up those gains by being ahead of the pending market correction.  I have put money into inverse ETF's (they make money when the underlying index goes lower) since everything I have learned about these markets tells me we will end up lower than we are now.  Nobody can call the exact top for the markets.  In this case, it turns out I was too early. 

Even though the saying is that the market can stay irrational longer than one can stay solvent, I still expect to make up the difference, and then some, in the longer run.

The Basic Timing Model is doing slightly better than the TSX index as money makes its way into the stocks for larger companies - many of which make up the XIU ETF.
 
Two month return for TSX @ Feb. 28, 2011 = 5.37 percent
Two month return for Basic Timing Model using XIU = 5.4 percent
Two month return for Advanced Timing Model (my returns) = -2.7 percent
Money for charity = $411.27

The Price Of Gas

In the coming episode of, "Nobody could see it coming", we'll get to debate why we are spending billions of dollars on bailouts, stimulus, and infrastructure, without ever giving real consideration to any planned conversion to natural gas.  Sure, Boone Pickens has been making noises in the U.S., but up to this point, little has changed.  The price of natural gas has long been below the level where it would save companies money to switch from oil to gas.  As I was driving to Toronto on Wednesday, there were points in time where, of the three lanes of traffic, two were almost solid with trucks, one after another, after another, for as far as I could see.  I don't remember seeing any which were fuelled by natural gas.

Why is it my hydro bill is going to double, at least, in the next couple of years because we want to pay hefty subsidies to the marginal providers of electricity generated by solar panels, and wind turbines, while we continue to ignore the fuel of which we probably have over a hundred years of supply?  Why is it we can afford to build the infrastructure for alternative energy sources, but not for larger, cheaper, energy sources?  Do politicians really think we are going to switch to electric trucks, any time soon?

In the mean time, the current economic recovery, if it can be called that, could be in serious jeopardy.  While it may have been difficult to foresee the magnitude of the Muslim revolution throughout many of the oil producing nations, it isn't too hard to do the math when it comes to figuring out who is most in need of most of their oil.  Did not anybody stop to consider that most of the oil revenues were going into the pockets of a small number of, mostly corrupt, individuals.  Was there no thought given to what would happen when the have-not's could no longer feed their own?  Is it not ironic that despite their denials, this whole situation likely has been made much worse by the monetary policies of those who are most dependent on foreign oil?  At this point, should we even be surprised?

I have said it before, and I'm saying it again - if people can't be that stupid, then they must be getting some form of compensation for doing what it is they are doing.  Think about it.  Using natural gas to, at least, power our transportation industries, would save money, be better for the environment, and create jobs.  These jobs would be needed to produce the natural gas, and to build out the required infrastructure while reducing dependence on foreign oil.  So why not?  The only conclusion one can come to is the politicians are serving the oil industry.  Why else would a country like Canada not want to replace oil with natural gas?  Why else would we not have better environmental standards?  It isn't like we don't know the issues regarding finding, drilling for, pumping, refining, and burning the stuff!

I feel like I am watching a bad episode of Laurel and Hardy - "Here's another nice mess you've gotten me into!"  Every time I go to the gas pump, now, I think about how it costs me a larger and larger portion of my income when fueling my car.  Every time I open my utilities bill, I am reminded of how much more government is costing me.  We scrapped the original electric cars so that we could bail out the auto industry for making obsolete products.  Now we could force the economy into recession, again, rather than clean up our act by doing the logical, more environmentally friendly, and cost-effective thing by reducing oil consumption and making natural gas the better alternative.

Let's just say I'm not about to run out to buy shares in any natural gas companies for awhile.  As for the arrogant politicians, despite even further costs, I can hardly wait for the next elections.

How high do you think the price of oil/gasoline can go?

The Efficient-Market Hypothesis

I have long known I am the luckiest person I have ever met.  Born prematurely, my size was such that others said, in those days, I was lucky to survive.  I have been granted the gifts of intelligence, great health, and various aptitudes.  I have survived car and bus crashes without a scratch when others were not so fortunate.  I also have the good fortune of living in a country filled with opportunity and, very often, with great kindness.  

As I have grown wiser, I no longer choose to call it luck.  Rather, my spiritual journey has taught me to see what I once thought of as being lucky as being blessed, instead.  I believe I live in a state of grace.  It so happens that Grace was also the name of the hospital in which I was born.

In that context, it particularly makes me smile when people tell me how lucky I am, or how much risk I must be taking in order to outperform the market.  You see that is not supposed to be possible.  According to the efficient-market hypothesis it is impossible to consistently achieve returns greater than the market average.  The theory states that the current price of any stock in the market is based on all of the information related to it and is, therefore, the correct price.  As such, a stock can never be under priced, or overpriced.  Given the technology of our day, I would suggest that if the theory ever was correct, it should be even more so at this time (reduced delays, better information, better distribution of information). 

We know that during a bull market phase, the price of the stock tends to be found above its 200-day moving average.  On average a decline of 20 percent or more in the stock markets starts after just about four years from the end of the previous decline of 20 percent or more and lasts for about one and one half years.  During these periods of decline, the price tends to be found below its 200-day moving average.

If I use the 200-day moving average as the point at which to buy and sell (depending on direction), I end up buying at a lower price (the 200-day moving average is lower the longer the price is lower) and selling at a higher price (the 200-day moving average is higher the longer the price is higher).  On average, using this approach, I should really outperform the market every five, or six years.

Of course that makes no sense to the efficient-market hypothesis, because the price doesn`t move higher or lower, it always reflects whatever the price should be.  It could be a gazillion dollars one day, fifty the next, and several thousand the next.  The price is, well, the price!  Interesting theory!

As a result, no matter how long I outperform the market with my returns, the efficient-market hypothesis suggests that since I cannot consistently outperform the market, luck is the only other possible explanation for doing so.  Without knowing much else about me, people must think I am the luckiest person alive.  I just want them to know that, personally, I feel I am much more blessed than I am lucky.  Call it what you will,  I guess I`d still rather be lucky than smart like those academics who can`t understand how, according to their models, it is even possible that anyone can outperform the market.       

Are We Due For A Market Correction?

1 Year TSX Index - daily prices (Click to Enlarge)

The chart shown is a daily price chart of the Toronto Stock Exchange for the past year.  We have been following along a nicely defined channel during that time.  It presents an almost classic Elliott Wave 5-wave pattern.  The convergence of the upper channel line, the price candles, and last trend line all suggest we should be very close to a top.  Looking at a chart of the S&P500 Index, I get a very similar result.

It is too early, yet, to tell if 20 year U.S. Treasury bonds are making a bottom (if only for the time being).  We are seeing a second week of gains for them after closing in on an almost three year trend line.  Earlier I blogged about the bounce in the commodities index.  It has now been going sideways for a couple of weeks.

It is impossible to call the exact top.  If anyone could do that, they would be more famous than Warren Buffet.  The point is, the likelihood of a correction in the market at this point, is greater than that of the market duplicating last year's performance without, first, correcting (despite any and all quantitative easing).  We never know what event will trigger a sell-off, but something will come along, people will perceive it as negative, and down goes the market.  Buy-and-holders won't care - they won't be happy, but they'll wait it out.  Me, I have already taken my profits.  I don't trust the markets to go much higher, so I am preparing for the correction.

As for the cause of market tops, I don't want to imply they are caused by certain events.  The real cause is the lack of new money being put into the markets.  A top comes when everybody who wants to get in has done so.  Buying dries up.  It is rather like trying to inflate a balloon with a hole in it.  As long as the amount of air going in exceeds the amount of air leaking out, the balloon will grow larger.  Stop putting in air, and the leak will cause the balloon to deflate.  Of course, if the leak grows larger, then the balloon deflates even faster. 

I am not a professional, and I can not give you advice, but as I said, I feel this is a good time for me to protect some of my gains.  I'm just saying!

Do you feel we are due for a correction?  Have you taken any profits?

P.S. The basic timing model I blogged about earlier wouldn't currently give us a sell signal until the market has corrected by almost 10 percent.  Where it would make us money is in the large corrections we see every 4 or 5 years, or so.

The Merger of the Toronto and London Stock Exchanges

Hunting dogs never follow the pack.  You will always find them running along ahead of the group.  At a fork in the road, they will pursue whichever fork attracts their attention.  Should the hunters take the other path, the dogs will scramble through the brush until they are, once again, leading the pack.

Sound familiar?  Sound like any politicians we might know?  I had blogged previously about the potential costs from the government blocking the Potash take over.  Since the politicians saw nothing wrong with what they did the last time around, they are about to put their foot in it again.  Up to this point there are few popular political points to be had either way.  If there are any, they would be found in protecting Canadian financial services and Canadian jobs (in the short term).  The Canadian banks are hardly going to support more competition for their newly formed Alpha exchange.  Oh, remember the reason for creating Alpha in the first place was to provide competition for the Toronto Stock Exchange (TSX).

I find it interesting how the politicians were against the Potash take over, as was the electorate, at large.  The same government was in favour of competition in the mobile telephone sector despite uncertain foreign investment rules (as was the electorate).  Now, I doubt the merger of the TSX and the LSE will happen because there are few, if any, votes to be won by making it happen.  How's that for consistency (especially the vote getting part)?

So why should we, as investors care?

Let me start by pointing out the aversion business has to government interference and tax grabs.  We have a unique opportunity in the post financial crisis period to create a stable environment in which to attract foreign capital and business.  The result would be more growth, more jobs, perhaps even a more diversified Canadian economy.  Governments that focus on vote-getting and tax grabs do little to inspire businesses to make large capital investments.

Are we really in such denial that we think Canada is such a great place to work and play (which it is) that businesses will just ignore how difficult it is to navigate all the red tape and, in the end, be subject to the whims of politicians at the local, provincial, and federal levels?  I laughed out loud when everyone was quick to point out how protectionist our fellow Americans were, when it was our own provincial trade barriers which were the real reasons they didn't want to relax their constraints.  We wanted to be able to play in their back yard as long as they weren't allowed to play in ours!

Our banking system is seen as being one of the best in the world.  One could make the argument that it is our rules and regulations that got us to this point.  I might point out that the amount and type of regulation is irrelevant when governments just make up the rules as they go.  How many foreign investors did Canada lose with the change in the Income Trust rules?  How many because of the increase in Alberta oil royalties?  How many because of the Potash deal?  How many if we stop this merger of stock exchanges?

Two things are abundantly clear.  First, we need to define, then follow, the rules we expect investors to abide by so they don't feel they are being ambushed all of the time.  Then, we need one (national) regulator to enforce those rules.  While we are at it, why don't we give that same regulator the power to protect you and me and our fellow investors from ponzi schemes, corporate crime (think Bre-X) and the like.

As for me, I am tired of all the fighting between different levels of government, and self-serving agencies, especially the all-talk and no-action part.  I am even more fed up (pun intended!) with governments which rely on the absence of clear regulation to twist events into situations for vote-getting.  While it guarantees them a job and furthers their pension, it is costing you and I real money, money which comes out of our own investment funds, and pension funds.

How do you feel?  Are you in favour of the merger between the TSX and LSE?  What about having a national regulator?