You’ve probably heard a lot of people talk about the P/E ratio. It’s one of the most popular fundamental analysis numbers out there. Moreover, it has earned a reputation as one of the key ways we value stocks. And in my book, it’s one you simply can’t avoid.

In a nutshell, the P/E ratio gives us a clue into the real value of a stock. It does so by taking the price of the stock and dividing it by the company’s earnings over the last 12 months. Spelled out:

P/E Ratio = Stock Price / Yearly Earnings

Let’s say XYZ is selling for $20 a share. Over the last 12 months, the company has earned $2. As a result…

XYZ P/E Ratio = $20 / $2 = 10

Since XYZ stock is currently selling for $20 and over the past 12 months the company has earned $2 a share, XYZ’s P/E ratio is 10.

So getting the P/E number is pretty straightforward. But by itself, figuring that XYZ has a P/E of 10 doesn’t really do much for us. It’s just the starting place that makes valuing a company easier. Without it, we’re sort of left in the dark about whether a stock’s price is really worth what people are paying for it. So now we need to dig deeper.

Using the P/E Ratio Makes Valuations Easier

Think about it a second. In our example above, XYZ is selling for $20 a share. But how do we know that $20 a share is a fair price for XYZ?

First off, we take XYZ’s P/E and compare it with other companies in XYZ’s industry. If other companies in the same industry carry P/Es lower than XYZ’s, then we say the XYZ is “overvalued.” Let’s look at a real-life example…

As you can see from this graph, IBM carries a P/E ratio of 12.8. That means its share price is valued at nearly 13 times its last 12 months of earnings. The average P/E for companies in IBM’s sector is just 10.7. As a result, we can figure that IBM is slightly overvalued.

In other words, compared with other companies in its marketplace, you’re going to pay a little bit more for IBM than other players. And the P/E ratio helped us get to this determination very quickly and with very little fuss.

Since IBM is slightly overvalued, does that mean we shouldn’t buy the stock? Not at all. While the P/E ratio tells us something about IBM’s value, it’s not the whole story.

IBM (NYSE:IBM) is an industry leader. So just as with any big-name brand, you’re going to pay a little bit more for it. And in my book, the slight difference between IBM’s P/E of 12.8 and the sector’s 10.7 is well worth the premium.

Now, if you are looking to invest in a company with lots of solid growth prospects, you’re quickly going to see that the company’s P/E ratio could easily be much higher than IBM’s 12.8. And the reason that’s so is pretty simple…

Companies with high growth prospects command a higher P/E ratio because investors believe the growth rate is going to translate into higher stock prices down the road. And since stock prices reflect what investors think is going to happen to a company, these high-growth companies usually carry higher P/Es.

Should these higher P/Es drive us away? Not necessarily. Companies with higher growth rates are going to deserve higher P/Es. But the higher P/Es have to be justified by other solid fundamental factors, like exciting new products, top management and good financial operations.

Look at Both the “P” and “E” for Historical Comparisons

In addition to comparing a company’s P/E with its sector, I also like comparing its current P/E with what’s happened in the past. Let’s take another look at XYZ…

Currently, the company carries a P/E ratio of 10. But let’s say that a year ago, XYZ’s P/E was 8. So what does this tell us about the value of XYZ?

Looking just at these numbers, I would conclude that XYZ is becoming higher valued. In other words, investors like the growth prospects for XYZ and are bidding up the stock’s price to prove it.

But before we pop open the champagne, it’s a good idea to take a look at what’s happened to both parts of XYZ’s P/E over the last year.

If the “P” – the price – of XYZ has gone up and XYZ’s “E” – earnings – have gone up, then we’re looking at a growth company that’s commanding a higher stock price. In my book, that’s a positive.

But if the “P” of XYZ has gone up and the “E” has remained the same – or, worse, gone down – then investors are piling into XYZ without much care for earnings. While that’s not always a bad thing, a lower “E” with a higher “P” is certainly cause for concern in my book.

P/E for the Broader Market

No matter what kind of company you’re looking at, it’s always a good idea to have an idea of where its P/E stacks up against the stock market as a whole. And a good way of doing that is to look at historical P/Es for the S&P 500. Take a look at the next graph.

As you can see from this graph, the P/E ratio for the broader U.S. stock market fluctuated between 17 and 25 from March 2005 to September 2008. In fact, the average P/E for the S&P 500 was 19.5 during this period.

In December 2008, the S&P 500’s P/E ballooned to 61. With my data going back to 1936, this is by far the highest P/E on record. And with the mess the market and the economy were in, it goes without saying that this astronomical P/E wasn’t driven by high growth and excellent earnings.

So what’s the takeaway? Simply, that when looking at P/Es for the broader market, it’s important to pay attention to long-term trends with exceptions – like last December’s quarter – taken into consideration.

Drawbacks to the P/E Ratio

Just like every indicator in the book, the P/E has drawbacks. And you need to keep these in mind when you use this popular ratio.

First off, the bottom of the equation – the earnings part – is calculated by the company based on accounting rules. And while many of these rules are in place to protect investors, there’s little doubt that figuring out how a company arrives at its “E” is a monumental task.

Companies can also massage numbers to make their “E” more attractive. And I don’t have to tell you that the unscrupulous ones aren’t above just plain falsifying their books.

But that’s not all…

The P/E ratio can also be calculated using different time frames for the earnings part. The one we’ve used here – the trailing 12-month historical P/E – is the most common, but sometimes the P/E is based on projections that haven’t happened yet. As a result, projected P/Es are less reliable to me than historical P/Es. And you have to know which kind of P/E you’re dealing with.

Best wishes,
Wayne Burritt

Source: The Secret of Wall Street’s Most Powerful Number

Super-investor Warren Buffet once said that his investment philosophy was to buy stocks when others were fearful, and to be fearful when others were buying. Right now isn’t the time to be fearful along with the herd; it’s time to stock up on stocks.

As I predicted earlier in the year, right now the market is zooming higher like there’s no tomorrow.

Let’s begin with this chart of the S&P 500, a good proxy for the broader U.S. stock market…

As you can see, shares of U.S. companies have been soaring. In fact, from a low of 667 on March 6 to a recent high of 1033, the market is up a mind-boggling 366 points.

Translation: U.S. stocks have improved a whopping 54.9% in just a matter of months.

The fact is the market made positive moves long before the economy was showing a ton of life. And if you don’t jump in early, you’re likely to miss the best moves.

And now, with the 960 level for the S&P 500 — the top of the resistance range — clearly out of the way, U.S. stocks are now setting their sights on the next big resistance level of 1313, set way back in August of last year.

Now, getting there won’t be a straight line: 300-plus point moves don’t usually happen like that. So there will likely be the occasional, healthy pullback along the way.

But there’s no doubt: From a technical perspective, the 1313 level on the S&P 500 is the next order of business.

And don’t forget: When we make it back to this level, we’re getting very close to the pre-recession highs of 1500-plus. While that’s by no means a done deal, there’s little doubt we’re headed in the right direction at a solid pace.

But it’s not just the market’s technical factors that have me jazzed. The fundamentals are on the right track, too…

Fundamentals Improving Big Time!

For a while now, I’ve said that the housing market got us into this mess and the housing market will get us out.

Well, the facts are in: Housing is beginning to show consistent signs of life.

Sales of existing single-family homes jumped 7.2% in July compared to the month earlier. That’s the largest increase since the National Association of Realtors began tracking data way back in 1999. Plus, it marked the fourth monthly increase in a row.

In other words, the improvement in the real estate market isn’t just a flash in the pan. It’s here to stay.

But that’s not all. Compared to July 2008, home sales were up a solid 5%. That’s the first year-over-year gain since November 2005. And that means the real estate market is showing significant legs, even when dealing with tough year-ago comparisons.

Another positive: The improvement in home sales is geographically broad-based. Take a look at this chart…

As you can see, home sales improved across the board during July. In fact, they’re up 13% in the Northeast, 11% in the Midwest and 7% in the South. Only the West region showed a small 2% decrease.

And it’s not just the real estate market that’s showing solid fundamental action. The broader economy is looking good, too. According to Federal Reserve Chairman Ben Bernanke…

“Fears of financial collapse have receded substantially… After contracting sharply over the past year, economic activity appears to be leveling out, both in the U.S. and abroad, and the prospects for a return to growth in the next year appear good.”

And he’s not alone. According a survey of economists by the Wall Street Journal, 28 of 45 respondents say the recession is already behind us, and 16 say it will end by December of this year.

I don’t know about you, but that’s a hugely bullish factor to me. But there’s more: GDP forecasts are also on the rise. Take a look…

As you can see, economists are calling for a big improvement in GDP over the next year. In fact, even though GDP contracted 6.4% and 1% in the first and second quarters of this year respectively, analysts are looking for improvements for next four consecutive quarters in the 2.1% to 2.8% range.

Bottom-line: Stock prices are zooming higher and are now cleared to take out levels not seen since August of last year. In addition, strong fundamental factors — including an improving real estate market, a huge call for an end to the recession and solid GDP projections — are adding solid foundation to more price surges. And no matter how you slice it, that’s positive for your portfolio.

Best wishes,
Wayne Burritt

Source: Stocks Are Set to Rocket in September

Take a look at this daily chart of the S&P 500:

The S&P 500 is a good proxy for the broader U.S. stock market. And as you can see, stocks continue to march higher. In fact, from a low of 667 on March 9 to last Thursday’s high of 889, U.S. stocks have shot up a mind-boggling 33%.

But that’s not all. Take a gander at the large arrow on the left of the chart. It marks the summit of the market’s last upside run. Because the market reversed course to the downside that day (Feb. 9) and at that level (875), that peak is called – in technical parlance – a “resistance” level.

The market also failed to penetrate this resistance level just a few trading days earlier, on Jan. 28. All told, that means 875 is a pretty tough point for the market to get above.

That’s why the market’s most recent action is more significant than most investors and traders are thinking: It smashed above key resistance at 875 like a walk in the park. No doubt about it, that shows uncommon technical upside strength.

Here’s the best part: When the market breaks through resistance – especially after failing to do so in previous attempts – that resistance level has an excellent chance of becoming a stopping point when the market decides to turn down again.

In other words, strong resistance – once defeated – becomes solid support for future price action. So when the market pulls back – and it surely will – it’s very likely to not fall too much below 875. And I don’t have to tell you that can be very reassuring.

There’s more good news. Just as I thought, the most recent run continues to be backed by higher average volume. And on the chart, that’s marked by the upward sloping average volume line near the bottom of the pane.

Significant? Certainly. When strong upside runs – especially when they include breaks above strong resistance levels – are powered by increasing average volume, it’s a clear sign that higher prices are attracting more investors and traders. And they’re buying more and more shares to prove it. That means lots of upside pricing pressure in the days and weeks ahead.

But before we start the big celebration, take another look at the chart. Notice that while the market has surged higher, it’s done so with very few significant pullbacks.

In other words, the market’s most recent run since the beginning of March – including a staggering 33% pop in prices – has been practically straight up.

I don’t have to tell you that’s a ton of upside action in a short amount of time. And for someone who’s been around the block a time or two like me, that’s a red flag.

Why? Because like many things in life, markets don’t go straight up for very long. And if they do for a while, it only makes sense that they’re going to pull back and take a breather.

Plus, big run-ups mean some traders are likely sitting on some juicy profits. So when they take some of that money off the table, that selling pressure will cause prices to drop.

Here’s what I’m looking for: Over the course of the next few months, we’ll likely see a significant pullback in the 10-15% range. On the S&P 500, that means a drop of 90 to 134 points.

Now, it probably won’t happen violently and quickly. I think there’s just too much investor optimism for that. But it could easily happen over a few weeks, with downdrafts in the 1-3% range.

Best wishes,
Wayne Burritt

Source: Why You Should Remain Cautiously Optimistic as the Markets Surge Higher

In addition, the wealth effect is a brand of self-fulfilling prophecy, which makes it even more powerful…

By investing in stocks that go up, we have more wealth.  Having more wealth causes us to go out and spend.  That spending, in turn, causes the economy to grow.  Economic growth then leads to better times for companies which, in turn, lead to higher stock prices.

Unfortunately, the power of the wealth effect works in reverse as well…

When we see our stock portfolios getting hammered, we feel a lot less wealthy.  That loss of wealth causes us to pull back on spending.  Less spending means slower economic growth, which is lousy for companies.  Poor outlooks for companies mean lower stock prices.

And declining wealth isn’t limited to stocks.  Take a look at this chart of real estate prices…

As you can see from this graph, the year-over-year change in home values — indicated by the dark solid line — began to slow around the beginning of 2006.  But economic growth — indicated by the red dashed line — didn’t begin to slow until the middle of 2008.

In other words, the wealth effect in real estate wore off long before the economy began to sputter.  In this case, the declining value in real estate was a huge leading indicator of poor economic activity to come.

In fact, changes in just about any asset — from stocks to houses to commodities — can cause their owners to adjust their spending habits.  And those spending adjustments are going to happen after the owners’ assets take a hit.  And that makes them a great predictor of where things are headed.

I’ve told my readers time and time again that a recovery in real estate prices — and stability in the real estate market — is likely going to be one of the biggest pluses for a stabilized economy and higher stock market values.  Real estate got us into this mess and it’s going to get us out.

Using These Leading Indicators for Profit

So, how can you make money off the predictive abilities of the stock market and other asset classes?

Simple.  While others are waiting for the big economic indicators — such as solid growth, the labor market, and the credit crisis — to get back on their feet, you can slip into key investments long before anybody else gets wind. The markets are telling us loud and clear patience will be rewarded.

Source: Profiting from the Wealth Effect

This from Penny Sleuth:

Sectors are sections of the economy that have similar characteristics. They’re really no more than groups of companies that are in the same business.

In other words, if the economy is like the theater, a sector is the orchestra section within the theater. Smaller than the theater itself, but not quite an individual seat yet.

Standard & Poor’s – the huge financial data provider and publisher – has things broken down into nine sectors: Consumer Discretionary, Consumer Staples, Energy, Financial, Health Care, Industrial, Materials, Technology and Utilities.

S&P’s nine sectors break down the economy nicely!

There are certainly tons of ways to break down the economy outside of these nine sectors, but I like to use S&Ps sectors for a couple of reasons.

First, they make sense. Take a tour around these nine sectors and you’ll find just about every kind of business represented. From financial powerhouses to utilities and health care, S&Ps sectors are a great place to delve deep into sector research. In fact, all told, these nine sectors represent all of the companies in the S&P 500.

But here’s the bigger reason. Each one of these sectors is represented by an exchange-traded fund (ETF) called a Select Sector SPDR (Standard & Poor’s Depository Receipt). An ETF is a fund that tracks an index – read: sector – but, unlike a mutual fund, is tradable like a stock.

So if I’m interested in a particular sector, I can actually buy the sector by investing in its corresponding Select Sector SPDR. That’s why in the graphic above, each Select Sector SPDR has a symbol next to its name: XLF for Financial, XLK for Technology, and XLU for Utilities, and so on.

But that’s not all. Since Select Sector SPDRs trade like stocks, they can also have options attached to them. That’s great for our purposes because if we get interested in an entire sector – and not just a company in that sector – we can make a play on it.

Here’s another reason I like focusing on a sector’s ETF: Since they trade like stocks – and unlike an index – ETFs can reflect actual investor interest in a sector. You can use investor interest gauges – such as volume, buying and other related technical analysis methods – that simply can’t be used on an index.

Source: The Inside Scoop on ‘Top-Down’ Investing