What is your view of one of the more popular tools associated with relative ratio analysis, the price to earnings ratio?
The P/E valuation tools is a great way to screen stocks. It is not perfect, but is easy to understand and apply. The investor will have to knowledge of the current market's P/E ratio and that of the sector that the stock in question resides in. No one tool for valuation is full proof, but the P/E tool is extremely easy to apply and can be done in ones head - which is valuable for quick analysis and potential decision making. Just like any tool, it is to used by the investor to aid in getting the job done and not as holy grail.
Do you think the measure of P/E is a valuable tool for stock analysis? Explain and justify your response.
As stated above, it is valuable tool for the investor. Quick and easy to apply is the power of this tool. The danger is solely relying on this tool as a catch all and the holy grail. The intent of tools is not to be this, but to aid the investor in finding their way through a maze - which direction should they go.
Are the current markets under, fairly, or over priced?
http://home.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&newsId=20070927005589&newsLang=en
This article suggests the market may be under to fairly priced, but there are several discussions in this article that suggest otherwise. It appears that maybe only a few select sectors fit this criteria and not the market as a whole.
The current market, in my opinion, is probably fairly to over-priced – depending on the sector and specific stock. P/Es are creeping up again and this is potentially dangerous sign. Many P/Es are greater than 15 and mainly close to 20. As the market valuation gets back to more basic fundamentals, the market is probably generally over-priced and will correct itself. Companies with high P/Es will have to justify this valuation through strong operational cash flow, strong and effective R&D budgets, low debt, and not be over leveraged.
Responses to the posted article about current “bullishness” in the market and also stated are other questions about the future markets. There are several statements that suggest that the present market is undervalued or fairly valued, but the prices projected in the future may not be so bullish. The financial engineering or the creation of innovative products has lead to discovery of their flaws, which has lead to the current crunch. As stated in the article, “the summer brought several troubling financial issues to the forefront” suggest that scionomics may be playing a part in the bullish attitude. The weak dollar is also helping the market coupled with the continued “bad news” about Chinese companies. The technology sector is currently bullish and the financial sector is bearish right now. The weak dollar is making our exports cheaper abroad and any imports more expensive. Companies with strong manufacturing presence in the USA are seeing an increase, so why are consumer discretionary and services sectors and materials and processing sectors bearish? Is this because of the outsourcing of the past couple of decades is a concern? The advantages of outsourcing manufacturing are no longer being realized due to the weak dollar?
The statements in the article “…call equity markets either fairly valued or undervalued, managers participating… there may be new reasons to begin considering fixed income investments..” does not sound like a bullish statement or that the present value of stocks are really under or fairly valued by these managers. The article goes on to say how “bullishness for corporate bonds more than doubled … US Treasuries recorded one of their highest bullish scores … Are these managers just playing a scionomic game and making sure investor/society confidence remains optimistic? There appears to be a “flight to safety and that managers fundamentally believe that the bigger opportunity still lies in the equity markets … it is true that risk is being repriced ..” by the market. This statement in the article suggests to me that the market may be overpriced, but no one knows until risk is revalued – no one knows what the risk premium on equity should be over treasuries. This suggests that stocks can not be adequately valued, so how can these managers comment on the market being under or fairly valued – when they do not even understand how to value the current market? Review the current yield curve, the 1 month rate was 3.40 % and the 6 month rate was 4.20% or a pretty steep upward sloping curve. Couple this with rising fears of a recession and oil reaching $100 per barrel – is the market overpriced? The article suggests that many managers are bracing themselves for inflationary pressures and looking for safe havens for periods of recession and inflation. The strong increases in gold and silver suggest inflation is looming.
The article finally tells us where the managers see under or fairly priced stocks and it is in large cap growth and not the market as a whole. The title is thus a little misleading and meant to draw the reader in. These companies are a safe haven probably due to low debt, great cash flow, and strong brand recognition. These companies have great credit and not a default risk. These companies also will remain very liquid, due to these reasons. They can continue to offer commercial paper and issue bonds without concerns from investors. These companies also need short-term debt instruments, where small cap etc may be after long-term debt instruments. Review of the yield curve reveals that the investors are not very interested in long-term bonds. They are having strong expectations of higher interest rates to come (based on the pure expectations theory).
One last note here, the links provided are about the Feds power and ability to control the overall market and economy. It suggests that the tools the Feds has are out dated and not effective anymore. The deregulation of the industry has dampened their power. Their tools are really for depository institutions and the market is not controlled by just depository institutions. This sub-prime mess was caused by non-depository institutions, so do we need to reevaluate how the Fed operates to correct the current issues at hand?
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921012/1016/ECONOMY
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921011/1016/ECONOMY
Saturday, September 29, 2007
Wednesday, September 26, 2007
Further Reflections on Module 1 - Sub-Prime Shakeout
Financial innovation and the Global Liquidity Factory
Lets just raise the following: 1) When it is stated that derivative structures are “…virtual and not real” what does this suggest about the value of financial innovation, broadly defined as “…the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets” (Peter Tufano, Financial Innovation 2002 at http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf).
2) Following up on the article (“Are we headed for an epic bear market?” at http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx?page=1) that states While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear. The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
Two questions on the claims about a global liquidity factory:
I. What does the class think of this article’s claims?
A) Completely right
B) Somewhat right
C) Too pessimistic
D) Don’t know and II.
Based on your answer to the above, how should you allocate your assets?
Articles
Peter Tufano link . Below is another link to his paper + another one on the subject.
http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf
http://www.hbs.edu/research/pdf/07-082.pdf
http://www.nyabe.org/fergusonspeech.pdf
http://hbswk.hbs.edu/item/5745.html
Comments and Reflections
Interesting comments and articles, so knowing what I know now – where would I place my assets? I think Mark hit it pretty close. Precious metals (gold) are not really one place where I would put any money. This is based on history. Even though the price of gold is high right now, it really just getting back to the 1980 price after a decline for many years. But commodities are probably a great place. Now we all know that past performance does not predict future performance, but wheat has more than doubled, oil continues to increase – as well as corn and sugar. But I also know these markets are better left to the experts and I am not an expert on the commodity markets. So that being said, I would keep my liquid assets in short-term Treasuries and long-term investment in large to mid-cap value companies like GE, PEP, MMM, GLW, MSFT, and stocks like this have low betas, low to zero debt and lots of cash. Currencies would have been a good investment, but the chances that there would collaboration among global banks are probably pretty good. Also cooperation and collaboration among government, the Federal Reserve, regulatory agencies, and financial institutions will have to work together to sift through this mess and minimize the global damage. I still think the stock market is solid for the most part, but growth stocks are in potential trouble – due to the credit crunch. Problems will probably loom for 10 years. The S&P Case-Schiller Home Prices Indexes predict falling house prices in certain markets for the next five years and these devaluations are 15 to 20% - not 1 to 5%.
All of these financial innovations or derivatives started in 1986. Numerous new derivatives products were placed in the market. This is probably why many people did not understand them exactly. Derivative had been around a long time and people understood them. My guess is that they all assumed that the new derivatives were just improvements on the older ones – more efficient, etc. The financial engineers knew that the sum of the pieces were greater than the value of the whole in tact. This was proven by the corporate raiders, etc. These financial innovators just had to figure a way around the laws and regulations in order to create this value. Getting around taxes and regulations has been the single greatest motivator for these financial innovations. Turning short-term gains into long-term gains to avoid paying higher taxes or basically greed was involved to increase their profitability and cash flows. Greenspan’s dropping the federal fund rate lead to a large amount of liquidity injected into the market. These financial innovations just applied a multiplier to this existing liquidity, which allowed to easy money. Everyone seemed to forget that derivatives were created to transfer credit risk – diversify the risk – and not to create virtual money and earn high interest rates. Mortgage rates where at the lowest rate in like 30 years. Loan originators were all making in excess of $100,000/year and brokers were probably in excess of $500,000/year. All of these people work basically on commission – no loans no paycheck. If the employees were making this kind of cash (you may have 10 to 15 LOs in one office) how much do you think the financial institutions were making? Also we can all see the motivation was not to be ethical or to work on the fine line of legal and ethical boundaries in order to close the most loans. A high risk – low credit score – so what just charge them 50 to 100 bps more, the interest is still low. Also this greed lead to the ARMS, etc. mortgage product innovations, which further aggravated this entire sub prime issue. This all lead to an explosion in the M3 money supply.
M3 – includes all of the time deposits, money fund balances, Eurodollars, and repos. All basically due to the “financial innovations” of derivatives by the financial engineers. Then the Fed decided to stop tracking and monitoring the M3 money supply in March of 2006. This seems to have left the system unchecked by anyone. Why did the Fed decide to stop monitoring M3? If they stopped tracking it because they could not get their arms around it, then they just decided to stick their heads in the sand and hope for the best.
Financial institutions could use the advances in technology to improve process and system efficiencies or use technology for product innovations and marketing schemes. It is obvious that is was easier to create money through product innovations and clever marketing and packaging schemes than it was to change their operations. The short-term immediate gain without any regard to consequences was chosen instead of a more long-term approach of improving processes and systems to control and eliminate risks.
Lets just raise the following: 1) When it is stated that derivative structures are “…virtual and not real” what does this suggest about the value of financial innovation, broadly defined as “…the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets” (Peter Tufano, Financial Innovation 2002 at http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf).
2) Following up on the article (“Are we headed for an epic bear market?” at http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx?page=1) that states While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear. The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
Two questions on the claims about a global liquidity factory:
I. What does the class think of this article’s claims?
A) Completely right
B) Somewhat right
C) Too pessimistic
D) Don’t know and II.
Based on your answer to the above, how should you allocate your assets?
Articles
Peter Tufano link . Below is another link to his paper + another one on the subject.
http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf
http://www.hbs.edu/research/pdf/07-082.pdf
http://www.nyabe.org/fergusonspeech.pdf
http://hbswk.hbs.edu/item/5745.html
Comments and Reflections
Interesting comments and articles, so knowing what I know now – where would I place my assets? I think Mark hit it pretty close. Precious metals (gold) are not really one place where I would put any money. This is based on history. Even though the price of gold is high right now, it really just getting back to the 1980 price after a decline for many years. But commodities are probably a great place. Now we all know that past performance does not predict future performance, but wheat has more than doubled, oil continues to increase – as well as corn and sugar. But I also know these markets are better left to the experts and I am not an expert on the commodity markets. So that being said, I would keep my liquid assets in short-term Treasuries and long-term investment in large to mid-cap value companies like GE, PEP, MMM, GLW, MSFT, and stocks like this have low betas, low to zero debt and lots of cash. Currencies would have been a good investment, but the chances that there would collaboration among global banks are probably pretty good. Also cooperation and collaboration among government, the Federal Reserve, regulatory agencies, and financial institutions will have to work together to sift through this mess and minimize the global damage. I still think the stock market is solid for the most part, but growth stocks are in potential trouble – due to the credit crunch. Problems will probably loom for 10 years. The S&P Case-Schiller Home Prices Indexes predict falling house prices in certain markets for the next five years and these devaluations are 15 to 20% - not 1 to 5%.
All of these financial innovations or derivatives started in 1986. Numerous new derivatives products were placed in the market. This is probably why many people did not understand them exactly. Derivative had been around a long time and people understood them. My guess is that they all assumed that the new derivatives were just improvements on the older ones – more efficient, etc. The financial engineers knew that the sum of the pieces were greater than the value of the whole in tact. This was proven by the corporate raiders, etc. These financial innovators just had to figure a way around the laws and regulations in order to create this value. Getting around taxes and regulations has been the single greatest motivator for these financial innovations. Turning short-term gains into long-term gains to avoid paying higher taxes or basically greed was involved to increase their profitability and cash flows. Greenspan’s dropping the federal fund rate lead to a large amount of liquidity injected into the market. These financial innovations just applied a multiplier to this existing liquidity, which allowed to easy money. Everyone seemed to forget that derivatives were created to transfer credit risk – diversify the risk – and not to create virtual money and earn high interest rates. Mortgage rates where at the lowest rate in like 30 years. Loan originators were all making in excess of $100,000/year and brokers were probably in excess of $500,000/year. All of these people work basically on commission – no loans no paycheck. If the employees were making this kind of cash (you may have 10 to 15 LOs in one office) how much do you think the financial institutions were making? Also we can all see the motivation was not to be ethical or to work on the fine line of legal and ethical boundaries in order to close the most loans. A high risk – low credit score – so what just charge them 50 to 100 bps more, the interest is still low. Also this greed lead to the ARMS, etc. mortgage product innovations, which further aggravated this entire sub prime issue. This all lead to an explosion in the M3 money supply.
M3 – includes all of the time deposits, money fund balances, Eurodollars, and repos. All basically due to the “financial innovations” of derivatives by the financial engineers. Then the Fed decided to stop tracking and monitoring the M3 money supply in March of 2006. This seems to have left the system unchecked by anyone. Why did the Fed decide to stop monitoring M3? If they stopped tracking it because they could not get their arms around it, then they just decided to stick their heads in the sand and hope for the best.
Financial institutions could use the advances in technology to improve process and system efficiencies or use technology for product innovations and marketing schemes. It is obvious that is was easier to create money through product innovations and clever marketing and packaging schemes than it was to change their operations. The short-term immediate gain without any regard to consequences was chosen instead of a more long-term approach of improving processes and systems to control and eliminate risks.
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