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What Do P/E Ratios and Dividend Yields Say About Stocks Future?

Nov 11, 2011
Simon Maierhofer

Based on P/E ratios, stocks are the cheapest in over a decade. Other valuation metrics however, suggest a frothy market top. Is it possible to invest safely in this market or is it simply untradable and unpredictable?

An October 31 Bloomberg article said that: “More than 10,000 estimates suggest the S&P will advance to 1,447.93. Analyst forecasts imply the benchmark measure will post its biggest rally since the 1990s technology bubble, when the gain since March 2009 is included.”

Wow, that’s a pretty big statement. Analyst estimates are largely based on earnings-based valuations. “The last four quarters EPS total of $94.80 (for S&P 500) exceeds the previous peak of $91.47 achieved in second quarter 2007,” according to Goldman Sachs.

You are probably tempted to re-read this statement, but it’s true: Earnings just came in at an all-time high, stocks didn’t. What does this mean and what’s the chance of the S&P rallying to 1,447.93?

Don’t Ignore Analyst Estimates

It’s no secret that I don’t have much respect for Wall Street analysts and their analysis. But that doesn’t mean you have to ignore them – use them as contrarian indicators. Here are some popular 2011 forecasts given in December 2010:

December 16, 2010 – USAToday: “Experts agree. Get over your fear and get back into stocks.”
December 18, 2010 – Barrons 2011 Outlook: “Our group of investment experts sees stocks continuing their climb next year as the economic recovery takes hold.”
December 29, 2010 – Seattle Times: “Economic rebound forecast for 2011.”

Looking at the same valuations analysts used, the December issue of the 2010 ETF Profit Strategy Newsletter simply stated that: “Over the long-term, stocks are priced to deliver pain, not gain.”

Record earnings in 2007 spelled trouble for the market and record projected earnings for 2011 foreshadowed trouble for the market.

Are Valuations out of Date?

The fact that corporate profits in 2011 trumped the previous 2007 all time high boggles my mind. According to Standard & Poor’s, the P/E ratio (based on reported earnings) is at 14.48 (as of 9/30/2011) and projected to drop below 13 in 2012.

Merely judging by the P/E ratio, stocks are as cheap today as they were in 1989, the last time S&P had a P/E ratio below 15. Does that make sense?

It doesn’t, but here’s what’s driven earnings: 1) Corporations have “fired” their way to record profits by firing hundreds of thousands of workers. While this has caused a short-term profit spike it has eroded their customer base.

2) The “E” (earnings) of P/E has never been more manipulated. New accounting rules have allowed banks (NYSEArca: KBE) and financials (NYSEArca: XLF) to post profits even as toxic assets continue to erode
their financial stability.

Unlike earnings (and the P/E ratio), dividend yields can’t be manipulated. Either a company pays dividends or it doesn’t. Dividend yields are near an all-time low. The S&P 500 (SNP: ^GSPC) pays a meager 1.96%, the Dow Jones (DJI: ^DJI) 2.68% and the Nasdaq (Nasdaq: ^IXIC) 0.78%.

Even the SPDR S&P Dividend ETF (NYSEArca: SDY) has a yield of only 3.26%. The iShares Russell 1000 Value ETF (NYSEArca: VTV) pays only 2.42%. One bad day on Wall Street (and we’ve had many of those) can wipe out an entire year’s worth of dividends.

Low dividend yields are commonly seen at market tops and directly contradict the upbeat message of low P/E levels. In fact, dividend yields are within striking distance of their 2007 level and not much higher than in 2000. Which indicator would you rather trust, one that can be manipulated or one that can’t?

Is the Market Untradable?

The good news is you don’t have to trade to make money. In fact, you don’t even have to be invested to make money. That’s right.

Assume for a moment you sold all your stock holdings in April (as the ETF Profit Strategy Newsletter recommended). Even though your portfolio statement wouldn’t show a gain since then, you would have made money (as in increase your purchasing power). You could buy back the S&P you sold at 1,350 for 1,250 or less. In other words, you could buy 7.4% more shares of the S&P for the same amount of money.

If you do want to trade the market, there are plenty of opportunities. The key is to be on the right side of the market. Valuations suggest that the long-term direction for stocks (NYSEArca: IWB) will be down. What about other indicators?

Opportunities Abound

While Wall Street is perplexed by Europe’s whac-a-mole approach to its financial problems, the market continues to react to support/resistance levels like a pet to an invisible fence.

Structurally important resistance was outlined via the April 3 ETF Profit Strategy update: “Even though odds do not favor bearish bets the first half of April, I believe a major market top is forming. The down sloping trend line of a giant head and shoulders pattern will traverse through 1,377. The 78.6% Fibonacci retracement is at 1,381.5. There is a fairly strong Fibonacci projection resistance at 1,369. In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.”

The S&P spiked as high as 1,371 on May 2 and peeled away from resistance thereafter. The initial peeling away turned into an all-out meltdown.

Just as Wall Street proclaimed a new bear market (October 4 headlines: “S&P enters bear market territory” – Reuters and “S&P falls to the bears” – TheStreet) the October 2 ETF Profit Strategy update expected an important low:

“Based on the studies discussed in the August 14 and 21 TF, I’ve been expecting new lows followed by a tradable bottom. I define a tradable bottom as a low that lasts for a few months and leads to a bounce that (in this case) should propel the markets around 20%. Therefore the recommendation is to buy once we’re near the low.
The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”

On October 4, the S&P opened at 1,097, briefly dipped to 1,075 and closed at 1,124. From low to high, the S&P soared nearly 220 points (20.2%) in less than a month.

The Next Opportunity … Just Around the Corner

On October 27, the S&P hit its up side target and has staged a choppy decline since. Investors seem to expect a year-end rally, which is evidenced by bullish sentiment (see most recent AAII or II sentiment polls).

Retail investors (often considered the dumb money) are the most bullish since February while investment advisors and newsletter writing colleagues are the most bullish since July. Seasonality remains strong for another couple months but events in Europe may well override any seasonal biases and surprise investors.

With so many variables, it’s best to let the market speak and watch how stocks react to the next resistance or next support. The stock market is at a short-term "make it or break it" point and a break below support may release an avalanche of bearish forces.

The ETF Profit Strategy Newsletter identifies important support/resistance levels (including the one support level that must hold right now) and provides straight forward, common sense short, mid and long-term forecasts along with actionable ETF profit strategies. 

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