AAII Journal Editor
Dogs of the Dow
Learn how to use this high-yield strategy.
Analyzing Stock Investments
The strengths and weaknesses of various valuation measures.
AAII Discussion Boards
How Do You Determine if a Stock’s Valuation is Reasonable?
This week’s AAII Sentiment Survey results:
Bullish: 36.5%, up 3.4 points
Neutral: 30.5%, down 3.4 points
Bearish: 33.0%, down 0.1 points
September 6, 2012
August 30, 2012
August 23, 2012
August 16, 2012
August 9, 2012
August 2, 2012
July 26, 2012
July 19, 2012
July 12, 2012
July 5, 2012
June 28, 2012
June 21, 2012
June 14, 2012
June 7, 2012
May 31, 2012
May 24, 2012
May 17, 2012
May 10, 2012
May 3, 2012
April 26, 2012
April 19, 2012
April 12, 2012
April 5, 2012
March 29, 2012
March 22, 2012
March 15, 2012
March 8, 2012
March 1, 2012
February 23, 2012
February 16, 2012
February 9, 2012
February 2, 2012
January 26, 2012
January 19, 2012
I had originally written solely about stock valuations, but I thought I should say something about today’s announcement from the Federal Reserve.
As you may have heard by now, the Federal Open Market Committee (FOMC) announced more monetary stimulus. The reason given is that the FOMC is “concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.” This is why the FOMC is increasing the amount of mortgage-backed securities it is purchasing, keeping their target for the federal funds rate at 0%–1/4% until mid-2015 (instead of late 2014 as they said last month) and is prepared to provide even more stimulus if necessary.
Federal Reserve Chairman Ben Bernanke is clearly more worried about a Japanese situation (an economy that stays stalled for a prolonged period) than the prospects of future inflation. The FOMC did, however, state an inflation objective of 2%. Though the number does not surprise me, I don’t recall previously seeing it in an FOMC statement.
Is this move controversial? Unfortunately, when it comes to economics, there are no control groups. You simply have to try something and hope your theory works in practice. We’ll never know what would have happened if a plan B was followed instead.
I realize many of you rely on interest income and do not view today’s statement as good news. Bernanke is operating on the assumption that if he remains the friend of borrowers long enough, lending will increase, thereby spurring growth. Unfortunately, in doing so, he is also remaining the enemy of savers.
Analyzing Stocks Based on Relative Valuations
Comparing a stock’s current valuation to a benchmark was a key theme in our September Stock Superstars Report and AAII Dividend Investing newsletters. Relative valuation analysis can help you determine if a stock is reasonably priced or mispriced.
Relative valuation models examine a stock’s current valuation with a benchmark. A stock’s price-earnings ratio, dividend yield or similar valuation ratio is compared against the overall market’s valuation, the industry’s average or median valuation, the company’s own historical average valuation or another relevant indicator (e.g., prevailing bond interest rates for dividend yields). These benchmark measures will fluctuate, but you would be concerned if the stock’s normal relationship to the benchmark has deviated. If a stock has normally traded with a valuation below the market average and now trades with a valuation above that of the market, it may indicate that the stock is overvalued.
For example, in our Stock Superstars Report portfolio, we chose to take a 108.5% gain in Comcast Corp. (CMCSA) in response to the stock’s price-earnings ratio of 19.5 times trailing 12-month (TTM) earnings. This valuation was higher than the 17.0 median price-earnings ratio for all stocks in the S&P 500 at the end of last month. A key rule to successful investing is to sell a stock when the reasons you bought it no longer apply; in this particular case, Comcast no longer possessed the low value characteristics that had enticed us to originally add it to the portfolio.
Historical valuation ranges can also help you identify whether or not a stock still possesses the valuation traits that first made it attractive to you. We recently deleted Chesapeake Utilities (CPK) from the AAII Dividend Investing tracking portfolio because of its yield. Appreciation in the stock’s price caused the yield to fall to a level that was more than 20% below its five-year average of 3.9%.
Notice that in both cases, neither stock was expensive on an absolute basis. That is the difference between absolute valuation (the stock’s current valuation) and relative valuation (how the current valuation compares to a benchmark). A stock can appear to be inexpensive on an absolute basis, but if its current valuation is above historical or market benchmarks, the stock is arguably expensive.
A good way to think about absolute versus relative prices is the housing market. A newer, four-bedroom house priced at $400,000 located in a small town may seem very expensive relative to other houses in the area. Plus, you may believe that it is simply unnecessary to spend that much on a house, meaning you are considering the house’s absolute value. Conversely, the same house in an upscale Chicago neighborhood will seem cheap relative to other houses in the area. Plus, you may view it as cheap on an absolute basis, because you would not expect to find such a low-priced house in that neighborhood. Alternatively, if you didn’t know where the house was located, but knew that over the past seven years, its value fluctuated between $375,000 and $475,000, you might conclude that the house is reasonably priced now.
Stocks are no different. The market assigns a relative valuation range based on a company’s industry, its trend in margins and its outlook. If the valuation falls to either the lower or higher end of this range, the stock is arguably mispriced. Keep in mind, however, that relative valuation is just one measure. If a company’s underlying financial trends, its business outlook or its industry conditions change, a reassessment of the company’s valuation may be warranted.
Still, relative valuation can serve as a useful guide for determining if a stock is cheap or expensive.
More on AAII.com
- Dogs of the Dow – The Dogs of the Dow strategy, which advocates buying the members of the Dow Jones industrial average with the highest yields, is one of the best- known relative valuation strategies. (A list of the current “Dogs” can also be found on AAII.com.)
- Analyzing Stock Investments: The Concept of Relative Value –This 1999 AAII Journal article explains the various valuation measures, and their weaknesses (in PDF format).
- Stock Superstars Report – This AAII newsletter uses four different strategies to diversify both by industry and by investing style.
- AAII Dividend Investing – Our newest portfolio follows a growth and income strategy to find attractively priced dividend-paying stocks.
- How do you determine if a stock’s valuation is reasonable? – Tell us on the AAII Discussion Boards.
- Don’t forget to take the Sentiment Survey.
The Week Ahead
Rosh Hashanah, starts on Sunday evening. To our Jewish members, l’shana tova.
We will see the first set of third-quarter earnings with a group of the early reporters announcing results. FedEx (FDX) will report on Tuesday. Adobe Systems (ADBE), AutoZone (AZO), Bed Bath & Beyond (BBBY) and General Mills (GIS) will report on Wednesday. CarMax (KMX), ConAgra Foods (CAG) and Oracle (ORCL) will report on Thursday.
The week’s first economic data will be the National Association of Home Builders’ September housing index, published on Tuesday. Wednesday will feature August existing home sales, August housing starts and August building permits. The September Philadelphia Fed survey and the Conference Board’s August leading indicators will be published on Thursday.
Four Federal Reserve officials will make public appearances next week. Chicago President Charles Evans and Richmond President Jeffrey Lacker will speak on Tuesday. Minneapolis President Narayana Kocherlakota will speak on Thursday. Atlanta President Dennis Lockhart will speak on Friday.
The Treasury Department will auction $13 billion of 10-year Treasury inflation-protected securities (TIPS) on Thursday.
Friday will be a quadruple witching day, meaning both options and futures contracts will expire.
AAII Sentiment Survey
Individual investor sentiment turned slightly bullish about the near-term outlook for stocks in the latest AAII Sentiment Survey.
Bullish sentiment, expectations that stock prices will rise over the next six months, increased 3.4 percentage points to 36.5%. Bullish sentiment remains below its long-term average of 39%, even with its slight upward bump. Bullish sentiment has been below its long-term average for 23 of the last 24 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.4 percentage points to 30.5%. Neutral sentiment fell just below its long-term average for the first time in seven weeks. The historical neutral average is 31%.
Bearish sentiment, expectations that stock prices will fall over the next six months, edged down 0.1 percentage points to 33.0%. While bearish sentiment is slightly above its historical average of 30%, it has been generally trending down as the market has climbed its “wall of worry.”
This week’s special question asked AAII members which industries or sectors they currently liked. The largest percentage of AAII members favored the energy sector, with 18% of responses selecting energy. The health care sector had the second highest response rate, with 13% of AAII members selecting this segment. Commodities (metals) and technology both got 10% of our members’ vote. Two percent of our members indicated that they were on the sidelines, holding cash.
A few of our members looked beyond industries or sectors when answering the question and indicated they currently favored dividend-paying stocks (6%), emerging markets (2%) or contrarian strategies (2%).
Here is the complete breakdown of responses:
- 18% Energy
- 13% Health Care
- 10% Commodities (Metals)
- 10% Technology
- 7% Financial
- 7% Real Estate
- 6% Capital Goods
- 5% Consumer Staples
- 5% Retail
- 4% Utilities
- 2% Agriculture
- 2% Telecommunications
- 6% Dividend-Paying Stocks
- 2% Emerging Markets
- 2% Contrarian Strategies
- 2% Cash
» Take the sentiment survey
Wishing you prosperity,
Charles Rotblut, CFA
AAII Journal Editor