I am often asked how I determine whether the stock market is
going to go up or go down during the next few weeks or months. No
one knows for sure which direction the stock market is going to
take, because there are too many variables that influence the
stock market, and unforeseen events can negate the best research
While I cannot predict what the stock market will do next, I know
I can enhance my investment performance if I invest more
conservatively when the stock market is high, and aggressively
take advantage of bargains when the stock market is low. This, of
course, raises the question: How do we gauge what is high and
what is low?
Some investors are capable of assessing the market's current
status by studying charts. I prefer to determine whether the
stock market is overvalued or undervalued by "running the
numbers." Any investor can determine whether the stock market is
reasonably valued. The trick is to determine when the market is
overvalued or undervalued.
I start by calculating a few ratios. The price-to-earnings ratio
(P/E) is simple. First, I add up the prices of all 30 of the Dow
Jones stocks. Then I add up all of the earnings per share (
). Finally, I divide the total prices by the total EPS to find
the P/E. To determine the EPS, I use the past two quarters and
estimates for the next two quarters. The current P/E is 14.7. The
historic P/E for the Dow Jones Industrial Average for the past 10
years is 14.0. Therefore, I can conclude that the current stock
market as measured by the P/E for the Dow is slightly overvalued
at 14.7 today compared to the historic average of 14.0.
But I don't depend on a simple P/E calculation to gauge whether
the stock market is overvalued or undervalued. I also compare
current and historic ratios for price-to-cash flow, price-to-book
value, and dividend yield. Right now, the Dow is slightly
overvalued according to price-to-earnings and price-to-cash flow
ratios, but slightly undervalued according to price-to-book value
and dividend yield ratios. I conclude that the market is just
about where it should be right now.
What about the future? By using some forecasting tools and
formulas I developed, I calculate the overvalue and undervalue
range for the Dow Jones for the next two years will be 14,504 and
9,615. Notice I didn't predict that the Dow will reach either
extreme, but if I had to guess, I would predict that the average
will stay in the mid to low part of the range.
As I mentioned in the beginning, I want to know if the market is
overvalued or undervalued so that I can invest cautiously when
the market is high, and take advantage of bargains when the
market is low. I advise using some caution, but as a long-term
investor, you should expect higher prices and continue to follow
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The 2011 North American International Auto Show is underway in
Detroit this week, and the publicity seems to be all positive.
The event will showcase 40 new vehicles manufactured by companies
from around the world. I'm not interested in buying a new car,
but I enjoy seeing the fancy new cars and eco-friendly smaller
Automakers are expecting to sell about 12% more cars and light
trucks in 2011 compared to a solid year in 2010. There will be
many new hybrid and electric vehicles and sedans, crossovers, and
SUVs with more fuel-efficient combustion engines, including
several new models from China.
With the average age of cars and trucks on the road today in the
U.S. at more than 10 years old, Americans will need to replace
their aging vehicles. Low financing rates and wider credit
availability will help push new-vehicle sales higher. Noticeably
better fuel efficiency as well as new hybrid and electric
vehicles will also attract buyers as fuel prices continue to
How can investors take advantage of the improved outlook for car
and truck sales? There are three companies in the automotive
sector that I really like: Ford is a U.S. manufacturer of cars
and trucks. Magna International is a Canadian maker of automotive
components and vehicle systems. Tata Motors is India's leading
Ford Motor (
produces cars and trucks. The company and its subsidiaries also
engage in other businesses, including manufacturing automotive
components and systems. It also finances and rents vehicles and
equipment. Ford lost more than $7.1 billion in 2008, but has
recovered remarkably without borrowing from the U.S. government.
Ford has a very heavy debt load of $117 billion, although the
company also holds a high cash balance of $40 billion. The
company will likely earn $1.90 per share in 2010 and $2.05 in
2011 while sales rise substantially. With the leveraged balance
sheet, EPS could increase more than forecast, too. The company is
cutting back the number of models that it makes, which will save
manufacturing costs. New model changes and the company's
international consolidation endeavors bode well for increased
market share and cost efficiency. Ford does not pay a dividend
now, but probably will reinstate a small dividend within the next
couple of years.
Magna International 'A' (
is headquartered in Aurora, Ontario. Magna designs and
manufactures a diversified line of automotive components and
vehicle systems for automakers throughout the world. The company
is gaining significant market share because of its manufacturing
flexibility, dependability, and geographic reach.
Automotive manufacturers are opting to outsource part of their
operations to a few large component and system makers like Magna
rather than outsource to many small component makers. The
outsourcing trend is helping the company to expand rapidly and
garner a larger share of the market.
Sales likely increased 37% in 2010 and could increase another 12%
in 2011. Earnings improved from a deficit of $1.34 per share to a
profit of $4.20 per share in 2011 and another profit of $5.00 in
2011. At 14.6 times our 2011 EPS forecast, MGA shares are quite
reasonably priced. The company recently raised its dividend,
which now yields 1.2%.
Tata Motors (
is India's leading automotive manufacturer, but also produces
buses and tractor-trailers. The company took a big gamble when it
purchased Jaguar/Land Rover two years ago. Investors dumped TTM
shares knowing that Jaguar would bring substantial deficits to
Tata. But the deficits didn't last long, because Tata turned
Jaguar around quickly.
For the 12 months ended 9/30/10, Tata's earnings increased from a
deficit of $2.16 per share to a profit of $3.31 per share.
We expect forward 12-month EPS of 3.50 with future profitable
years almost assured. Sales increased an impressive 58% during
the past 12 months from a year ago. The company's Nano mini-car
is a big hit, and Jaguar sales are soaring. At 7.7 times our
forward 12-month EPS estimate, TTM shares are clearly
undervalued. The company pays an annual dividend yielding 1.2%.
Tata's balance sheet is heavy with debt, but the company's much
improved cash flow should allow a quick pay-down of long- and
short-term debt. In addition, the company raised $750 million in
a secondary stock offering, which will be used to help lower its
debt. The company is in a cyclical industry, and the volatile
share price swings are not for the faint of heart, but I
recommend buying TTM shares at the current price.
Investing is a serious business. We are investing our life's
savings, saving for college expenses and retirement, and putting
money away for many other important life events. Just as serious,
though, is our state of mind toward each other and toward the
world we live in. The tragic events in Tucson, Arizona,
re-emphasize what can go wrong when anger and misconceptions
There has been a lot of rhetoric placing the blame on the angry
and inflammatory speeches of politicians, news media, and others.
But aren't we all to blame? We can all surely begin to set better
examples for our children, friends, co-workers and even
Six months ago, I spoke at my son's funeral during the saddest
week of my life. I emphasized that he was a very kind young man,
very positive in life, and a true friend to everyone in
attendance. As the large gathering was about to leave, I asked
every person to set goals to be kind to one another and to make
every effort to become better friends. My son set a great example
for his friends. Now I ask you to be kind, friendly, and to make
this a better world in which to live.
J. Royden Ward
For Cabot Wealth Advisory
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