Archive for PE Ratio
Stock Market Analysis – Negative Divergences
Posted by: | CommentsDear Traders
It was a tough day on the US Markets yesterday and as I write this most of the major indices futures are negative. This could be a continuation of the correction that began on the 22nd of February 2011.
Taking a look at the chart of the S&P 500 we see there are a number of technical factors that support the assumption that the market will continue the short term downtrend is has just begun.
Click to Enlarge - SP500 Negative divergences of RSI and MACD - Chart Courtesy of Worden Brother Inc.
- Since December 2011 the market embarked on a strong bull run, yet RSI 14, 2 has formed a long negative divergence.
- In my last post on January 22nd I warned of a negative divergence forming – the market has continued to move up but is now looking significantly weaker.
- Since February 22nd, RSI has seen a strong drop and MACD’s charachter has changed from positive to negative.
- We have seen a volume surge as prices have moved down since February 22nd, which is usually a bearish sign.
What is a Positive or Negative Divergence in the Stock Market Chart?
A Divergence is a way for us to compare the direction of an indicator with the direction of price. When the indicators start to move in the opposite direction to price this is known as a divergence. Positive Divergences refer to when an indicator starts to move up as price is moving down. A Negative Divergence is when an indicator moves down when prices continued to move up.
Ben Bernanke suggested yesterday that a continued rise in fuel prices would negatively impact the US economic recovery. That is not rocket science, is is simple economics. We may see as fuel prices are continuing to rise that this will affect the stock market directly.
Is the Market already overpriced?
The US economy is in a fragile state and the debt burden it bears is absolutely incredible. Trying to support that debt burden in combination with high unemployment and the Obamacare costs will be tough. Having a fiscally weak president is also not helping the matter. The US is a fantastic and dynamic place to do business, but at some point it’s leaders will need to start to manage Fiscal and Monetary Policy responsibly. It can of course inflate its way out of its debt situation. But as we know strong deflation or strong inflation can be catastrophic for the stock market.
Historic PE Ratio of the SP-500 Index Source: http://en.wikipedia.org/wiki/P/E_ratio
The above chart shows the PE Ratio of the S&P 500 historically (blue line), you can see how overpriced the stock market was at each of the major Busts;1929 and 2000 specifically. Today we are at a PE of circa 22, which by any stretch of the imagination is not cheap. One could say given the state of the US economy and the challenges it has ahead, it may be overpriced.
Summary
In summary, we may be looking at a short term trend change to the down side. Will it turn into a medium or long term negative trend? Only time will tell. But if inflation increases significantly or energy prices continue to surge then I suggest it will. Keep this in the back of your mind as you place your trades.
10 Steps to build a great stock market trading system
Posted by: | Comments10 Building Blocks to a Professional Stock Market System
After you have undergone stock market education in fundamental and technical analysis you will be ready to start to create your Stock Market Trading System. Of course any good educational service in the equities/security space should help you to create this system yourself.
Developing a stock trading system is about combining logic, knowledge, experience, art and science. Your system will need to perform well (higher than 6% on average per year) both historically and be expected to perform well in the future at least for the time-frame in which you expect to use it. The “Nirvana” of a trading system is that it would need to perform well and need little “user interpretation” for it to function. This would mean using “trading robots” or a mechanical method. I do not recommend a trading robot that would place your trades for you as this will essentially take any on the fly decision making out of your hands. However you should use a mechanical method (computer) to help you test your systems and create the buy and sell signals for you.
In this context your systems would have the following requirements.
- A good stock trading system will need to be back-tested to prove that it worked in the past. This would give us an element of proof that the logic upon which we base our assumptions are functional.
- A good system allows us to trade with less emotion providing a market advantage. Emotion is known to be the culprit of many trading errors and losses.
- Automation of the fundamental screening for the stocks will save us a lot of time.
- Automation of the Technical Indicators Scan will also narrow the list further to enable us to focus only on our preferred candidates.
Step 1 – Get educated
Take a high quality stock market training course. This site has a FREE 10 module Stock Market Training Course, covering fundamental and technical analysis. For help on choosing a quality stock market education read this Stock Market Training Review.
Step 2 – Choose your favorite time-frame for trading / investing
If you have the time to fully immerse yourself in the Stock Market you might want to trade shorter time-frames (days to weeks). If you have a full-time job and less free time available you may want to trade longer time-frames and only monitor your stocks on a weekly basis.
Step 3 – Choose your favorite Markets
As an active trader you should choose your Stock Markets wisely. If you want to be active (checking your stocks intra-day or on a daily basis) then is may be wise to trade a stock market that is not in your time-zone. For example, Mr. Smith has a busy day job and only has time free in the evening. Mr. Smith is based in India. Normally he would want to trade the Indian Stock Market. But actually the European Markets might be a good choice as they open close to the end of his working day. Therefore he can dedicate and focus his spare time on the stock market in question.
If you are a less active trader, then it might be wise to trade the stock market in your own time-zone as you may have the advantage of being able to spot successful companies in your country and investigate them further using your “Local Knowledge”.
Step 4 – Understand what your profit target is
What is your target? Active traders should expect higher returns/profits as they will be spending more time trading the market. Less active traders might expect a slightly lower return as the trade off for not being as focused. But what is a good target. Do not believe the scam artists of “Penny Stocks Newsletters” and peddlers of “Microcap Stocks” ; in the real world 100% or 1000% profits are not realistic, in fact it is irresponsible that they would promote their services in this way.
Warren Buffet has averaged just over 24% annual return over his entire career. That is just 2% per month. Realistically you should choose this as a viable upper target.
Step 5 – Select you favorite Fundamental Screens
Capitalization, Earnings Per Share, Earnings Acceleration, 5 year revenue % increase, Price Earnings Ratio. If these terms are simply vague notions to your, please go back to step 1.
Step 6 – Select your preferred Stock Market Indicators using technical analysis
What Charts should you use?
- Bars
- Candlesticks
- Point and Figure Charting
- Ichimoku Cloud Charts
- Market Profile
What indicators should you use?
- Price Indicators – the study of price based chart indicators or Oscillators know as Stochastics,”Relative Strength” (RSI), “Rate of Change” (ROC), “Moving Averages” (MA), “Moving Average Convergence Divergence” (MACD), Parabolic SAR, ADX Average Direction Movement Index.
- Study of Volume – understanding how the level of volume has a relationship with price – and how price has a relationship with volume.
- Study of Price Volume Indicators – “On Balance Volume” (OBV), Chaikins Money Flow, “Time Segmented Volume” (TSV), MoneyStream.
Step 7 – Turn your previous choices into specific rules
Quantify your choices of the fundamental screens and technical analysis screens.
At what point would you by?
- When the 10 day Moving Average crosses the 20 day moving average and holds above price for 2 days?
- When RSI holds above the RSI 5 days Moving Average for 2 days?
At what point do you sell?
- When MACD turns negative?
- When you see a negative divergence in Money Flow?
Step 8 – Run your rules and back test
Using back-testing software you can start to implement your rules and see if they actually work historically. This is a fascinating and immersing topic. One excellent back-testing software I use is called stock finder.
If the systems produces the targets you expect, move to step 9.
Step 9 – Let your rules run
Let your rules run for a week or two to see if it continues to perform.
Step 10 – Go or No Go
If successful – Implement the system – If unsuccessful – tweak the system and start again from step 5.
If your rule are working then implement your system, start to trade it. If not you may need to refine the system. The best systems have been refined over and over again to remove logical errors and improve the percentage of winning trades and the % of the profit per trade.
The results of a great stock trading system
Building and running a trading system takes time, a logical mind and patience. Many successful traders have started to make losses because through boredom they have deviated from their winning system or strategy. Try not to make the same mistake.
The results will be profits and plenty of them.
Good luck and may the trade be with you.
Is the Stock Market Overvalued Still? – P/E Ratio for the S&P500
Posted by: | CommentsThe question on everyone’s lips – Up or Down !
To answer this let’s look at the PE Ratio of the Index.
One interesting statistic of a fundamental nature is the comparison of the earnings of a company compared to the stock price in the market. The Price Earnings Ratio (PE Ratio or P/E Ratio) is the Share Price / Earnings Per Share. This gives us the ability to compare companies in the same industry, or to see clearly what the expectation for a stock’s performance is. A P/E of 200 is extremely high, and a P/E of 5 is relatively low. But this all needs to be taken into context. For a detailed explanation of the P/E Ratio see the lesson “Is the company in great shape“.
We can also apply the PE Ratio to an entire index. Here you can see the PE Ratio for the SP500 calculated to June 2010.
A plot of the S&P 500 composite index price to earnings (P/E) ratio, and long-term interest rates in the US, from 1881 to 2008. Modeled on a plot from the book Irrational Exuberance by Robert SchillerWikipedia
I heard an analyst on Bloomberg yesterday suggesting that the S&P500 P/E Ratio was about 13, and could go as low as 10, then his company would start buying blindly anything that looked cheap. I do not know where he got his information but the research on the web shows most resources saying the PE for the SP500 is just a touch under 20. It is also interesting that a major fund managers strategy is to “buy blindly”. Does that give you confidence? This is why you can only trust yourself in the stock market and why we must really learn how the stock market works before investing.
A figure of 20 means that the index is not over-valued, but certainly not under-valued either. In original research in my book “The Liberated Stock Trader PRO”, I suggest that 20 is a modern level at which the market seems balanced in a healthy business climate. However is the business climate healthy today? Not really.
We see that the markets have been falling quite dramatically recently and volatility is increasing showing uncertainty of the market participants. The market can certainly continue its fall, it has a long way to go to the March 2009 lows. I personally do not think it will fall that far, but we can never say never.
A P/E for the S&P above 25 is certainly dangerous territory even in a healthy business climate. You can see from the image that each time this has happened the market has seen a correction there-after.
Conclusion.
Does the stock market have further to fall? In many cases at the moment we are in a secondary downtrend, and the markets are trading sideways until the February 2010 lows are surpassed.
When will the market turn around? We need to look for a trend change, and right now there are no signals that this is happening.
What about contrary opinion? Yes everyone seems to be very bearish at the moment, so this could indicate that the bottom is closer that we think, but this is simply opinion not hard facts.
Chapter 4 – Is the Company in great shape – P/E Ratio
Posted by: | CommentsThis is an excerpt from the Liberated Stock Trader Book and accompanying Training Course. Chapter 4 – Section 4 – The P/E Ratio
Now that we understand there are different types or stocks or companies out there we can take a look at how to fundamentally evaluate if a business is healthy or not. Having some knowledge that a company will not be declaring bankruptcy anytime soon is the minimum goal, however the more refined investor will be looking for stocks that are reasonably priced, have low amounts of debt or at least the ability to easily repay that debt, strong sales growth or revenue growth, a decent amount of cash in the bank, and solid earnings. Also, if you are familiar with the company’s product and how important that product is to the business can give you an additional insight.
