Written by Jared A Levy, Editor, Options Strategies Weekly
It is a big week, with lots of stocks in play. Alcoa (AA:NYSE), JPMorgan (JPM:NYSE) and Google (GOOG:NASDAQ) are just a few of the companies that will kick off earnings season this week.
To the average investor, earnings may seem like the same march of financial reports that happens each quarter. But for the select few who can get ahead of Wall Street’s expectations and understand exactly what to look for, it is a time to profit.
Think about it like this…
The stock market is the ultimate leading indicator of corporate and economic health. Investors buy and sell stocks based on emotions, economic data, news and chart patterns. These movements are confirmed by the strength (or weakness) of earnings reports. It’s sort of like a race with checkpoints along the way.
Believe it or not, the S&P 500 is in a position now that might surprise you.
Stocks on Sale
There is no doubt that my colleagues and I have cast a fairly bearish tone over the equity markets for the past several months. Fortunately, our thesis has played out profitably. But it is time to consider a change, if only for a short while.
I know you may think I’m crazy, especially given the shakiness of Europe and the overall negative economic data emerging from the U.S. But there is a reason…
I found some interesting and compelling indicators, the first of which you can see in the chart below.
Weekly P/E Chart of the S&P 500 — Courtesy of Bloomberg
View larger chart
This chart tracks the total price, earnings and estimates of all the stocks in the S&P 500 (SPX) over the past 12 years. The white price line is often a motivator for investors, but this time it means very little.
Price is relative. Remember price is just a dollar amount — value is determined in other ways.
Amateurs might look at today’s S&P 500 and think that because the S&P 500 is at April 2009 levels it is a reason to buy. Of course if you were to look back, investors may have said the same thing in October 2008, when the S&P was trading at levels not seen since 2004.
We all know that buying in October 2008 was NOT a good decision. So why are things different now?
I want you to focus your attention on the red and green lines. Try not to get dizzy.
These lines represent the expected price-to-earnings ratio and the trailing or realized P/E ratio respectively. They have been dropping along with prices.
The P/E ratio is the most popular measurement of value for a stock. Generally speaking, it’s good to buy when P/E ratios are relatively low and sell when they are high. It’s not the end all be all, but I have more data that may quiet the P/E naysayers.
Over the past 12 years of data shown on this chart, you can see that the ONLY time the S&P 500 even came close to its current P/E level (green) was in the crisis of 2009 and it was only about two points lower. The expected P/E is also in a favorable buying range.
The average P/E multiple for the S&P 500 over this time frame is about 19; a reading of 12 means value. As long as companies can at least meet their low expectations this season, we will see a rally, albeit short lived in this environment.
Backing It Up
Another indicator I look at is free cash flow (FCF). Free cash flow measures how easily businesses can grow and pay dividends to shareholders. Unlike income, FCF takes capital spending (capex) into account. It’s essentially the amount of cash being generated after all expenditures.
Many of my well-seasoned friends on Wall Street also pay close attention to this measurement and will often use FCF in unison with P/E and other indicators when determining value and growth potential.
I pulled up a chart of FCF for the S&P 500 over the same 12 years. As you can see below, real FCF (in yellow) is at all-time highs. This is another sign of strength within the average corporation.
To be fair, we are in trying times and capital expenditures, such as building a new factory, are probably down, but these numbers shouldn’t be ignored.
To Buy or Not to Buy?
Here’s how investors can profit from this information:
- The short-term investor can purchase shares in the SPY today and look for a rise in this index ETF over the next month and then quickly exit. Use the technical resistance levels of 1,200 and 1,220 in the S&P 500 as your cue to sell.
- Long-term (five years+) investors can use this opportunity to acquire a small position in the SPY or in a large-cap company they are building a position in. I discussed this technique in Smart Investing Daily.
I do believe there are challenges ahead, but expectations are near historical lows and any sign of strength should be met with a rally. I have a feeling we may see upside earnings surprises this quarter, moving the S&P higher.
Unfortunately, the market still remains in a bearish trend that will inevitably suppress most of the joy. Then there is the caveat that Europe mustn’t melt down as well.
If you are buying, do it cautiously and have a plan!
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