Many of the questions we've gotten in recent weeks are focused on the timing of the
economic and stock market recovery. The media has been fueling this fire, as there
are plenty of people calling this year's lows the market bottom before the beginning
of the new bull trend. In that light, I'd like to offer some help in determining the
true health of stocks.
There are a few indications that will signal the end of the bear trend, but we're
going to focus on three of the more important ones today. These three signs are the
200 day moving average line, price/earnings, and interest rates.
Price/Earnings ratio
We're all pretty familiar with the concept of P/E ratios (or price/earnings). This is
simply a quick measure of the cost of a share of a stock in relation to earnings per
share. A high P/E means the stock is relatively expensive, while a low P/E indicates
a bargain stock price. The historical average P/E has been about 16.7, although
recent averages push that figure nearer to 20. As a rule of thumb, many analysts say
'sell' when P/Es reach 19 or higher. That P/E of 19 may be laughable by the standards
set in 1999 and early 2000 (with P/Es as high as 100 or more). However, remember that
1999 and early 200 were the fluke - not the norm. That 19 P/E is a reasonable
standard. As of yesterday, the average P/E for the thirty stocks in the Dow Jones
Industrial Average was 19.33. Those 0.33 points may seem 'close enough' to 19.0, but
it's really not. And considering that the average P/E is 16.7, that 19.33 P/E shows
that stocks may still be overvalued.
Interest Rates
The bottom line is, stocks will go up when it makes more sense to be in stocks than
in other investments, such as bonds. If the return on a 30 year treasury is greater
than the yield on stocks, who'd want to sell bonds to buy equities?
So how do we compare yields? To calculate the percent yield of a stock, the P/E ratio
is simply turned into an E/P ratio. In other words, if the P/E is 20, then the yield
would be 1/20, or 5 percent. (If you have one of these, you can always calculate the
other). As of yesterday, the yield on the thirty Dow stocks was averaging 4.5
percent. The current yield on a 30 year treasury is better, at 4.83 percent.
To cross this hurdle, one of two things will have to happen: earnings (equity yields)
will have to improve, or interest rates will have to go lower (or both).
200 Day Moving Average
If there is an ultimate technical indicator, this is it. If the 200 day moving
average line is pointed higher, then so is the market. If it's headed lower, so too
is the market. And as you may know, the last few times we've approached the 200 day
line, we've hit it as resistance and moved much lower again.
However, in the last few days the 200 day lines has raised some eyebrows. For the
first time since September of 2000, the 200 day lines for most of the indices are
threatening to turn higher (and some already have). Additionally, all of the major
indices are simultaneously above their respective 200 day lines, again for the first
time since September of 2000. This is a decent sign, but these 200 day lines haven't
been tested yet. The 200 day moving average will have to act as support at the next
pullback to confirm a new bullish trend.
Keep these things in mind before blindly agreeing with someone who has said we just
hit the bottom. The 200 day average line requirement has not yet been firmly
fulfilled, and the other two criteria are still left unanswered. We may not have
these answers for weeks, or maybe even months. Until we do have clear answers,
caution is advised.
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