Mike’s Macro-Market Musings & Strongest IBD 50 Stocks

August 4th,

Today’s post has the regular update on the IBD 50, Running List and other watch list reviewed.  Additionally, we have an editorial by Mike Trager.  Mike’s Macro Market Musing for this edition is:

Mike’s Macro Market Musing:  Valuations?  We Don’t Need No Stinking Valuations!

The above title is a paraphrase of a famous line of dialogue from a very old movie, “Treasure of the Sierra Madre”.  The original line is apparently an observation that when circumstances are self-evident, proof or documentation is not necessary for validation of the situation at hand.

Any equity market observer or participant should be aware by now of the historic valuation extremes currently extant in the U.S. equity markets.  Depending on which valuation metric one might choose to employ, there is evidence that U.S. stocks are currently the most expensive they have ever been in the recorded history of the U.S. stock markets as measured by the common market indexes we monitor.  Most. Expensive. Ever.  More so than at market peaks prior to significant corrections in 1929, 2000, and 2008.  However, are the valuation metrics assigned to the indexes and duly reported by the mainstream financial media truly accurate?  Or have they been manipulated to the point of being deserving of our skepticism?  Do the “powers that be” have a vested interest in presenting this information in as favorable a light as possible?  Are other financial and economic measurements treated and reported in a similar favorable if inaccurate manner?  (Note:  your answer to the last 3 questions should be “yes”.)

Glad you asked.  Let’s take a look at how the reported price/earnings (P/E) ratio of the Nasdaq 100 is determined.  The P/E ratio is a highly flawed yet popular valuation metric, one that is easily distorted by the earnings number that is utilized; the price portion of the ratio is always beyond reproach.  While examining how the P/E of the Nasdaq 100 is commonly misrepresented, keep in mind that many of the same techniques are also applied to the Russell 2000 index of small cap stocks.

NASDAQ 100 is a mainstream index, intended to be the 100 largest firms of the NASDAQ Composite Index, which now contains over 3,000 firms. It is available via the popular PowerShares NASDAQ 100 ETF (ticker QQQ).  Just the top five holdings in the NASDAQ 100, which are Apple, Google, Microsoft, Amazon and Facebook, total 41% of the value of the entire index.  According to the PowerShares QQQ fact sheet, the P/E ratio of the NASDAQ 100 is currently 22.19x, calculated on a trailing basis.  The P/E – the price, in essence – is an important fact for some investors who are considering whether to own it or not.

QQQ P/E is not the simple mathematical average of the P/E ratios of all of the companies in the index, as one might naturally expect.  First, it is calculated by excluding all firms with negative earnings.  It also effectively excludes companies with excessively high P/E ratios. Would you do that? Does it make sense?

Let’s reason through the easy one first, the idea of excluding companies with negative earnings.  For the simplicity of round numbers, say an investor in private businesses made a $1 million investment in each of 3 small companies, flower shops, convenience stores, what have you, for a total of $3 million. One business earns $100,000 per year, so it has a price?to?earnings ratio of 10x; the second earns $50,000, for a P/E ratio of 20, and the third earns only $20,000 and so has a P/E of 50. This last one is probably situated on a high?growth street corner.  Averaging the three P/E ratios of 10, 20 and 50 means that the average P/E of the 3?company portfolio is 26.7x.  So far, so good.

But what if business number two loses $50,000 a year instead of making $50,000?   One can see that averaging the three P/E ratios would be misrepresentative, because then the average P/E ratio would be 13.3x (+10, ?20 and +50, divided by 3), which is one half as expensive as the original P/E of 26.7x.  Obviously, the portfolio with a loss generating company is not cheaper than the all profitable one. In a sense, the ETF organizers are staying within the logic of averaging individual P/E ratios by eliminating the company with the negative P/E ratio from the calculation as a statistical aberration or outlier. As if it does not exist or have an impact. The resultant P/E, however, does not represent reality.

To try representing reality better, how do we imagine the private investor would look at his or her investments? I think we all know they’d look at actual dollars. Perhaps they would add up all the earnings of the three businesses, which in the first instance was $170,000 ($100,000 + $50,000 + $20,000), and compare that with the $3 million of total investment:  that’s 17.1x earnings.  In the second instance, including the business that loses $50,000, the three together earn $70,000 a year, not $170,000.  Earnings of $70,000 is not a lot for $3,000,000 of investment; that’s 42.9x earnings or, in income yield terms, 2.03%.  That’s reality.

 So, in reality one knows that an unprofitable company makes an investment more expensive, while in the world of indexation, such as in the QQQ, unprofitable companies are eliminated, making the P/E lower.

Now for the more interesting technique of P/E reduction: neutralizing the impact of the excessively high P/E ratio. Companies with very high P/E ratios, say over 100, are effectively eliminated from the calculation of the QQQ valuation. For instance, in 2016, Amazon earned $4.90 per share. The trailing P/E for its current share price would be roughly 188.7x. Since Amazon is a 6.82% position in the NASDAQ 100 Index, its full inclusion would raise the index P/E by some appreciable and observable degree.

Similarly, by this convention, there is no way of informing prospective NASDAQ 100 purchasers of the valuation impact of holdings other than Amazon, such as Netflix, Tesla, and JD.com. Their trailing P/E ratios are 191x, -82x (yes, that’s negative), and 117x,respectively. Such names effectively do not exist from a P/E risk measurement perspective, even though as weightings in the index they definitely affect the risk of any dollar invested in the index.

Incidentally, measuring the NASDAQ 100 valuation in a manner more aligned with accepted procedure, by calculating the simple average of the P/E ratios of the 91 profitable companies, results in a valuation of 43.6x earnings. Or, even closer to accepted practice, if one calculated the weighted average P/E ratios of the 91 profitable companies (giving proportionately greater weight to the larger companies), then the QQQ valuation is 41.04x.

Despite reports and other evidence of historically extremely stretched overall market valuations, possibly the most expensive U.S. stock market ever, I think it should be a given that the markets are even more expensive than we think and by an appreciable amount.  I don’t believe we can even accurately assess, given the above considerations and examples of distortions in reported valuations, just what are the true current valuations of the market indexes.  I think it is safe to assume they are a good bit higher than we are being told.

Why does any of this matter for shorter term swing trading of the indexes and/or their derivatives?  Honestly, it doesn’t.  Valuations are of no use as timing indicators.  They are, however, incredibly predictive of longer term overall equity market performance and returns, the prospects for which are dismal.

BTW, much of the above information was excerpted from another source.  For those who are interested in further reading and information on this topic (I have only presented what I feel are the highlights), here’s the link:  http://www.zerohedge.com/news/2017-07-23/when-pe-not-pe-or-how-turn-90-22-three-easy-steps

Running List & Strongest Fundamental stocks on the IBD 50 for August 4th

Look for more earnings excitement next week as other leading growth stock report.  Will the market continue to demonstrate a mixed behavior?   we shall see!

Running List: 164 growth stocks have appeared on the IBD 50 in 2017.  Three stocks make their debut on the most resent list including, KEM, OLED and TSS.  Here is the total In and Out list, download the full list here:  Running List 8-4-17

Additionally, when the new IBD 50 list comes out twice per week I conduct a fundamental sort which results in the top fundamental IBD 50 stocks being identified. This sort is provided at:  IBD 50 8-4 Sorted

Lastly, to sign up Free Webinars for this week:

After Market Monday Webinar: GO HERE

How to Make Money Trading Stocks & ETFs Webinar August 11th: GO HERE