When politicians and media talking heads start throwing around numbers in the trillions or even billions it can be hard to comprehend. But when the conversation is about the government spending money that it doesn’t have, everyone needs to pay attention.

American workers receive statements from the Social Security Administration that tell them about their future estimated benefits, based on their work history and taxed Social Security earnings. On the front page of that statement is a heading that says: “About Social Security’s future…”

The second paragraph below the heading states this:

“In 2017 we will begin paying more in benefits than we collect in taxes. Without changes, by 2041 the Social Security Trust Fund will be exhausted and there will be enough money to pay only about 78 cents for each dollar of scheduled benefits. We need to resolve these issues soon to make sure Social Security continues to provide a foundation of protection for future generations.”

At the bottom of the page is an explanation that the estimates are based on intermediate assumptions from the Social Security Trustees Annual Report to Congress. Given the economic problems of the past couple of years and the trillions of dollars spent in an attempt to bolster the economy, one has to consider that Social Security might run out of money even earlier than these projections.

An article by Eric Sprott and David Franklin of Sprott Asset Management has more to say about U.S. deficit spending:

“The rating agencies’ ranking of the United States is even more disconnected from reality. To believe that the US sets the benchmark for sovereign debt credit ratings is preposterous. While we have written ad nauseam about the excessive debt issuance by the United States, we found a recent update written by United States Government Accountability Office (GAO) to be particularly instructive. The update noted the US’s budget deficit equivalent to 9.9% of GDP in 2009 — the largest since 1945 — and stated that without significant policy changes the US government would soon face an ‘unsustainable growth in debt.’

“This was not news to us. It goes on to state, however, that using reasonable assumptions, ‘roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020.’ This is news! In less than 10 years, using reasonable assumptions, there will essentially be no money left to run the US government - 93% of all tax revenues the US government collects will go to pay Social Security, Medicare, Medicaid and the interest costs on their national debt. This implies no money left over for defense, homeland security, welfare, unemployment benefits, education or anything else we associate with the normal business of government.”

This is important because the majority of Americans are counting on Social Security to fund a significant portion of their retirement financial needs. A recent study by the Center for Retirement Research at Boston College showed that in 2009, 51% of Americans were at risk of being unable to maintain their pre-retirement standard of living after retirement. That compares to just 30% 20 years earlier in 1989.

Greece is currently facing the type of debt crisis that could confront the United States in a few years. Greece simply doesn’t have enough money to meet all of its spending obligations. It has reached the point where no other country wants to extend Greece any more credit.

Because Greece is a member of the European Union (EU), its options for resolving its debt are few. Greece can’t simply hyper-inflate as some countries have done unless it is willing to withdraw from the EU. The available choices will all be painful for Greek citizens. There have already been strikes and demonstrations and civil unrest is likely to increase as the crisis deepens.

None of this is meant to imply that the U.S. government will default on its debts or that the government is destined for bankruptcy. There is certainly reason for concern, however, when government agencies like the Social Security Administration and the GAO are warning of a debt crisis.

For pre-retirees, this means that they need to be doing more to secure their own retirement. One way to help do that is by diversifying retirement options. Diversification across market segments has long been touted as a method to reduce market risk. But an even more secure approach is to diversify among various types of retirement instruments. That could include traditional pensions, IRAs, 401Ks, fixed income options, and a wide range of insurance products.

As the current economic crisis has shown, investments once considered low risk such as one’s own home, might not be secure after all. And under current conditions, relying on the government to fully provide for one’s retirement needs could be equally short-sighted.
F.S.

Right now the stock market is in the midst of a quarterly event known as earnings season. Four times each year corporations issue reports on their earnings for the prior quarter.  These numbers can play a significant role in market volatility depending on whether the earnings exceed or fall short of the estimates of stock analysts.

Most of the tools we use to assess the condition of the overall market or of an individual investment are technical or cyclical. Measuring investments on the basis of earnings is considered fundamental investing.

In a perfect world, the exact value of a stock could be determined by its earnings. Unfortunately, neither the world nor the stock market is perfect so stock valuations can fluctuate widely no matter their actual or projected earnings.

One of the more common methods of determining stock valuations is called the price-to-earnings ratio (P/E ratio). It is also called the earnings multiple. According to Wikipedia, the P/E ratio “is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.”

In simple terms a higher P/E ratio means that investors are paying more for each unit of net income. That means a stock with a high P/E ratio is more expensive when compared to one with lower P/E ratio.

Traders and investors sometimes use P/E ratios as a gauge to measure whether an investment or an index is over or undervalued. There are, however, several different methods for determining P/E ratios. So when using the P/E ratio as a measurement tool it is important to verify that the same formula is being used.

The standard formula is quite simple:

Price per share divided by annual earnings per share.

It becomes more complicated because there are several methods a company can use to define earnings.

The most common is a trailing P/E ratio. That means a company calculates its net income for the most recent 12 month period, divided by number of shares outstanding.

Sometimes instead of net earnings a company will calculate its P/E ratio using operating earnings. Operating earnings exclude earnings from discontinued operations, extraordinary items such as windfalls, write downs, or accounting changes.

Other companies use a forward or estimated P/E ratio. In this instance instead of using net earnings, the company uses projected 12-month earnings. Of course the average investor has no means to determine whether or not the company’s earnings forecast is accurate.

Other variations on the standard trailing and forward P/E ratios are common. For example, sometimes companies apply techniques to P/E measures such as rolling averages over longer periods of time to smooth volatile earnings.

Obviously all of this means that if an investor is using the P/E ratio as a method of valuing a specific investment, he needs to make sure he knows the methodology used to calculate that ratio.

Interpreting P/E ratios

In general, corporations want to have as low a P/E ratio as possible because it makes their stock appear more valuable. The simplest way to interpret P/E ratios is that the ratio number reflects the number of years that it might take an investor to recoup the price paid for the stock.

Again quoting Wikipedia, “The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average). An oversimplified interpretation would conclude that it takes about 14 years of earnings to recoup the price paid for a stock [not including any additional income from the reinvestment of those earnings].”

Of course stock prices can change rapidly and so can company earnings. So it is possible for a company to have a high P/E ratio one quarter and a much lower number in following quarters. For example, according to Standard and Poors, the P/E ratio of the S&P 500 Index was 122.41 for the second quarter of 2009. In the third quarter, the ratio fell to 84.30. By the fourth quarter of 2009, the ratio dropped to 21.88 as earnings of the companies included in the index rose.

There is a whole category of investing called “value investing.” The premise is that by purchasing stocks that are undervalued, there is a high likelihood that investors will bid up the price of the stock at some point and raise its value to an average or higher valuation. Berkshire Hathaway chairman Warren Buffett is a proponent of value investing.

P/E ratio is one of the most commonly used tools by value investors to help determine which stocks to buy. There is some subjectivity in this method. One trader might consider stocks with a P/E ratio of 10 to be a good value while another might only purchase investments with a 7 P/E ratio.

Low P/E ratios are not an indication of low risk. One caveat to this type of value investing is that a company might have a low P/E ratio because its earnings are in decline. In that situation, a low P/E number could be a sign that a company is in distress instead of just reflecting an undervalued investment opportunity. A good example is Ford. In April 2005 its P/E ratio peaked at about 32 with a share price of about 16. In September 2005 the stock price reached 29 and the P/E ratio was still near 30. But investors lost confidence and by the end of the year, the share price had fallen to 9 and the P/E ratio was at 8. But even at that low P/E ratio the stock price continued to fall. Today the stock is trading at about $3 a share and no P/E ratio is available because of a negative corporate earnings.

Conversely, high P/E ratios are not always negative. A company can have a high ratio because it has a favorable earnings outlook or because it is in a strong growth mode. On the other hand, a high P/E ratio can also indicate a speculative bubble. During the technology boom of the late 1990s many tech firms had extremely high P/E ratios (60 or more) because people believed the firms had unlimited growth potential. Some that survived have seen their P/E ratios decline to more typical levels. Others went under. And some still have ratios that are considered quite high.

Companies with no earnings usually have an undefined P/E ratio. This P/E ratio will usually appear as 0 or as N/A. Companies with losses (negative earnings) are also usually treated as having an undefined P/E ratio, even though it is possible to mathematically determine a negative P/E ratio.

As the current earnings season unfolds, it is important for investors to understand that corporations will always try to do whatever they can to present earnings numbers in the most favorable light. But positive earnings reports and solid P/E ratios are not always reliable indicators for determining whether a stock represents a good value.
F.S.

This week the National Bureau of Economic Research (NBER) provided more evidence about the incongruity of a rising stock market amidst a continued weak economy. In case you did not know, the NBER is the organization that officially determines the beginning and ending dates of economic recessions.

Monday, the NBER Business Cycle Dating Committee released a memo stating that after reviewing data pertaining to the current economic situation, it could not yet say that the upturn in economic activity means the recession is over. In other words, committee members would not certify that the economy has reached the bottom point of this negative cycle. The committee reaffirmed—based on relevant data—that the recession began in December 2007.

The fact that the members of this organization could not yet establish the end of the recession is significant, because it includes many of the nation’s most respected and prominent economists.  Founded in 1920, the NBER is a private, nonprofit, nonpartisan research organization that tries to explain how the economy works. Sixteen of the 31 American Nobel Prize winners in Economics and six of the past chairmen of the President’s Council of Economic Advisers have been researchers at the NBER.

The reason committee member cannot yet say whether the recession is over is because nothing like the current economic situation has ever occurred before. In spite of frequent media comparison to the Great Depression, the current recession is much different in many respects. The elements that caused it are different, the government reaction is different, and the existing financial regulations are much different. Apparently these experts agree that the current economic situation remains precarious and another downturn is still possible.

One thing that can be said for certain about this recession is that compared to recent economic downturns, it is severe and lengthy. According to the NBER, the most recent prior recession lasted eight months, beginning in March 2001 and ending in November of the same year. The recession before that was also eight months, beginning in July 1990 and ending in March 1991. The recession that started in July 1981 lasted 16 months until November 1982.

The quandary facing many investors is whether the stock market can continue rising if the economy is still in a recession. Unfortunately, no one knows the answer. One fact that is not in doubt is that the financial markets have risen sharply even though the economic recovery is still shaky.

Below is a chart of the Nasdaq over the past two years. Technology has been the strongest sector in this recovery and the Nasdaq has outperformed other major indices like the Dow Industrials or the S&P 500.

I’ve added some technical indicators to this chart to help us assess this index’s current situation.

On the top portion of the chart I included 50-day (Gold line) and 200-day (blue line) moving averages (MA). The fact that the price of the index is above both of these indicators tells us something that is fairly obvious: the index continues in a strong upward move.

The three bottom indicators all help determine whether the Nasdaq is overbought or oversold. When an investment is oversold, it means that selling activity has driven the price to a level where an upward rebound is likely. An overbought situation is just the opposite: buyers have bid up an investment’s price to a level where increased selling is likely to occur.

The middle indicator is a relative strength index (RSI). As you can see, it is currently above 80—the highest level it has reached over the past two years. When this indicator is trending above 50 that usually indicates the investment has enough positive momentum to continue an advance. But when it gets above 80 it normally indicates that the underlying investment must slow down.

The bottom section of the chart shows a stochastic oscillator. Like the RSI, when an investment exceeds a reading of 80, it is considered overbought and a downward move is expected.

Finally, the top middle section is a moving average convergence divergence (MACD). This indicator confirms that the index is currently at an overbought situation.

Each of these indicators is positive but at a high level. That means a downturn is likely soon, but it is not necessarily imminent. If the next downturn is similar to those that have occurred over the past year, it is not likely to be a major correction; rather, it could provide a good opportunity to add money to the market at a lower price.

At current levels, these indicators seem to show that this would not be a good time to take new positions in stocks. Patience is likely to reward investors with a better opportunity soon.

F.S.

I’m out of the office right now for a Spring break. Unfortunately, the weather has been anything but Spring-like.

The situation in the equity markets has not changed significantly from the prior week. Technical indicators remain mostly positive with cyclical indicators reflecting an overbought status.

The upward trend remains in place, but a corrective move is possible at this level.

Have a great weekend and watch for next week’s report.

 F.S.

With the market closed Friday for the Easter Holiday, we have a shortened trading week and abbreviated market report. Since early February, major indices have staged a strong advance. But this week, stocks have generally traded sideways.

The upward trend that has been in place for more than a year remains intact. But any time major indices start to flatten out there is some trepidation. The sideways pattern could continue for several weeks, as it did in November and December, or it could slide into a correction like it did in January. The third possibility is that it could resume its advance.

The chart below shows how three major indices have performed over the past six months. While all three currently have nice gains over that period, it has not been without opposition.

Acquaintances often ask me what direction I think the market is headed. I usually tell them that there are three possibilities: up, down or sideways. The variables that can impact the market are almost limitless. That means predicting what the market will do is impossible.

But forecasting is not the same as predicting. Forecasting market behavior is similar to forecasting weather. Tools and instruments are used to assess the current condition. The assessment is then compared to past periods that seem to exhibit similarities. Using as much data as possible, a best guess is made about what seems likely to occur.

Long-term trends might be the best indicator of near-term market behavior. Even though the current economic recovery is fragile and many economic fundamentals remain weak, for more than a year stocks have staged a strong advance.

At some future point, the momentum will shift and we will see another significant downturn. But with recent gains in employment, improving corporate revenues, rising retail sales numbers, and a president and Congress that have finally notched a win, this is not likely to be the starting point for the next major bear move.

F.S.