Archive for Stocks

Third Quarter Review – Weekly Update October 9, 2017 Recommended by Paul Ferraresi

2016 Election and the Stock Market

People have been calling me and cornering me at social events asking:

“What will happen to the stock market after the election”? In the short run of a day or a week there may be a bit of an adjustment. The real issue is the next four years.

Avoiding any political statements I address this strictly from an economic stand point and as a business owner. Unfortunately, I find most Americans cannot connect the dots when economic policies are presented.

Let’s examine things in light of Economics 101. What moves stock prices? Answer: Earnings (or some call it profits). As a simple example lets say we want to buy a “pizza shop.” The present owner has been earning (making a profit) of $100,000 per year. Lets say the profit equates to “cash profit.” Assume there are 100,000 shares outstanding so the pizza shop’s earnings per share are $1 each ($100,000 profit divided by 100,000 shares). A general rule of thumb is that one would pay about 4 – 5 times earnings (or profits) for a small business like the pizza shop. This is known as the PE ratio or the price earnings ratio. In our case that would equate to a selling price of $400,000 – $500,000. Thus, without changing anything and earning the same $100,000 per year, we, as the next owners, could get a return on investment in 4 – 5 years, or, in other words we are demanding a 20% – 25% annual return (simply divide the selling price $400,000 – $500,000 by the $100,000 profit to get the return number). The present owner would be selling each of the 100,000 shares to us at $4 – $5 per share ($400,000 – $500,000 sale price divided by 100,000 shares).

Now let’s assume after we buy the pizza shop we institute some changes, i.e., getting discounts for buying in larger quantities, teaching employees to be more productive or adding technology so we are able to now earn $200,000 in profit after tax in the next year.

What are some of the outcomes of our changes and hard work: (1) With higher profits more in taxes now go to the government. We see the need to begin advertising since we can now handle more business so the advertising company hires more people (who pay income taxes) to handle our account. We also hire more people to handle the anticipated new business (and the new employees pay income taxes). We ask for more products from our vendors they do the same and so forth and so on. This is known as the multiplier effect. By the way I am not advocating a love of taxes but rather showing the outcome of a growing business and economy. So, with Adam Smith’s “Invisible Hand” principal more people are working, which means they are off the Government dole, more taxes are flowing into the Treasury and more of our new customers are happy.

As a side bar, since our business is now making $200,000 per year (or $2 per share on 100,000 shares) the next buyer would be willing to pay us between $800,000 and $1 million or $8 – $10 per share under the classic 4 – 5 times price earnings multiplier. If we decide to sell the business we would owe taxes on the difference between the selling price of $1 million and what we paid originally of $500,000. So, it is the INCREASE IN EARNINGS that push up the stock prices. By the way the P/E ratio for the S&P 500 has averaged around 12 – 13 times since large companies are more stable and you would demand lower rates of return. I am using a small business example to explain the concepts. Keep in mind the companies that make up the stock market act similarly in concept to this small pizza shop.

Here is a major input to help you understand companies and the stock market. If you took all the companies in the U.S. from the small pizza shops, to grocery stores to Apple computer and added up their profits, the average profit for all the companies in the U.S. comes out around 4.8% (before tax). Yes, it is not the gigantic number people think exists. Grocery stores work on 1% profit while the “sin” companies like alcohol, tobacco etc. have much higher profit margins.

As any business owner, just like any employee, I want to maintain my income (earnings) and lifestyle. Let’s say we are able to maintain the earnings or income of $200,000 per year (or $2 per share) as noted above.

Next, let’s say my expenses skyrocket overnight because the government imposes higher income taxes on our profits, imposes costly new regulations and forces me to buy expensive health care insurance for employees. So, without any change in sales, expenses have gone up and my profits drop back down to the original $100,000. Please keep in mind it is not just our pizza shop that is hit this way. The advertising agency and all of our vendors are hit the same way plus all the other companies in the U.S.

So to maintain our lifestyles we have 3 options: (1) Raise prices, which will make us uncompetitive and is purely inflationary. (2) Cut costs by laying off employees which will restore our profits and lifestyle and make our employees miserable, or, (3) shut down the business. In all 3 options the Government will lose tax revenue and many people lose their jobs who now become a burden on society again by going back on the Government dole. How about selling the business? Well at $100,000 in profits we might get our original money back of $400,000 to $500,000 but the new potential owner has looked at our books and seen profits dropping plus costs going up, so I doubt we can get our money back in a sale.

Who loses here: The Government, employees and entrepreneurs.

Remember small businesses produce 70% of all new jobs created in the U.S. In the past year, for the first time in U.S. history, more small business are shutting down each month than are opening. Tragic!!
Small businesses are just a reflection of large businesses that make up the stock market.

Are you connecting the dots yet?

I hope you have the answer after this long winded explanation of what will happen to your wealth in the stock market after the election.

One candidate wants to (1) lower taxes on business (we have the highest corporate tax rate in the world. That is why many companies are leaving the U.S. and we lose jobs). Every time the Government reduces tax rates more tax revenue is generated. (2) This same candidate wants to reduce costly regulations that stifle the ability to start and maintain a business. (3) This same candidate wants to revamp the out of control costs to business of Obamacare. If this candidate can do this, it will lead to an explosion upward in business growth, employment, tax revenue and the stock market going through the roof which means your wealth will skyrocket.

Who wins here: The Government, employees, entrepreneurs and society as a whole.

The other candidate wants to increase taxes, regulations and health care costs.

This simple article has only covered a few policies that are on the table that separate the candidates. My desire was to answer the question on what will happen to the stock market.

Well, I hope you now can calculate and understand where the stock market will be in the next 1 – 4 years based on who wins the election.

In the great words of Mayor Daly……

“Vote early and vote often.”

Stock Market Signal

What will cause this next stock market major correction? In 20-20 hindsight the market always will tell you in advance what will happen. Markets always move from an overpriced position to an underpriced position. Alan Greenspan, in early 1998, shouted “Irrational Exuberance” to describe the market. Two years later the market dropped almost 50%. In 2007 “no doc” home loans peaked which led to the 40% market drop in 2008.

Recently, this market has been fueled by a non sustainable “binge drinking” liquidity flood. Some of the signals of a pending market correction are: (1) The Fed printing money and buying back bonds while greatly expanding their balance sheet. (2) Money has to find a home, either, into to money market accounts (no rate of return), or, real estate (near impossible to get a mortgage), or into the stock market (easiest route). It has been going into the market. (3) Companies are having a difficult time making a profit so they are fictitiously boosting earnings by buying back their own stocks. This puts money back into people’s hands, so, they then buy more stock. (4) The price people are paying for a company’s earnings is not sustainable. As James Donald, who played the doctor in “Bridge on the River Kwai” ended the movie with this line… “Madness, madness… madness!” This is what I see now in the market is madness. True, over the long run the market will do fine, but watch out below. Here are some additional factors for you to consider of why the market is overpriced.

There is a 50% decline in bearish sentiment which should all but guarantee a major market top. In fact, history in the form of a 40-year cycle, suggests a major market top is at hand. A 48% retracement of the advance from 1974-2015 would put the Dow at the 10,000 level by 2017, 2018, or 2019. This would match the 40-year retracement percentage for the 1973-74 bear market and be close to the 41% retracement for the 1937-42 bear market. The good news is that this would lay the groundwork for the next super-bull market, which could top out in the area of 150,000 on the Dow.

Please get into a hedged position, or, structure your investments that link to the market instead of being in the market. That is, when the markets rise you obtain the gain, when the markets crater… you do not lose a penny.

Contact us if you need assistance.

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Stock Market at Record Highs?

The media has been excited reporting that the Nasdaq has now surpassed the old record high 5,000 level as last seen in the year 2000.

But, investors are not even whole. Using a modest inflation rate over the past 15 years of only 2.2%, then, the Nasdaq has to be at 7,000 for investors to be even. Just think, having to hold a position for 15 years just to be even.

Let’s now look at the danger signs of the present market highs. Nobel laureate Robert Shiller commented on the CAPE ratio (which measures current S&P 500 prices against the index’s average inflation adjusted earnings over previous 10 years) extreme reading. The current reading is at about 27.5 which compares with just 15 at the market bottom in 2009. The only other times the CAPE has been higher, since the 19th century, was on the eve of the 1929 crash and in 2000 at the peak of the tech stock mania. Look out below.

The stock market bubble continues

Weak oil prices and low interest rates are a double edged sword. Although the consumer may be happy short term it is a troubling signal about the long term health of the economy. The markets, in general, are saying that they do not believe we are in for expanding economic growth. If the markets thought our GDP would grow at 4-5% then the bond market would get hit hard, yields would be rising, and stocks would be pulling back.

The average stock has gotten quite expensive relative to the market. People are whistling by the graveyard. Areas of concern looking forward:

    • Abenomics could fail to lift Japan out of deflation
    • Europe’s economy could continue to deflate pulling down the global economy
    • China’s growth could continue to sputter
    • Increased Terrorist activity worldwide
    • Russia standoff with Ukraine
    • Low oil prices push countries to invade others for raw materials
    • Federal Peserve raises interest rates prematurely