Archive for November, 2010

Sky-High in the Cloud

Cloud computing is all the rage these days.  There is a huge investor demand for the shares of market leaders in the space, and as a result their valuations are sky-high.  According to Yahoo!, VMware (VMW) sports a trailing P/E ratio of 115.  Salesforce.com (CRM) trades at 205.  Rackspace Hosting (RAX) is a relative bargain at P/E of 97.  These valuations are right in line with those of many high-tech stocks during happy bubble days of late 90’s and early 2000.  This is a cause for worry.

The good news is, that unlike 2000, these exuberant price levels do not affect the whole market.  In 2000, S&P 500 P/E was pushing 50.  Nowadays, overall market is very reasonably valued, and that includes most of high-tech stocks.  Even market darlings with triple-digit prices, such as Apple (AAPL) and Google (GOOG) have very reasonable valuations.

Cloud computing is indeed at the forefront of technology today, and one could argue that the market leaders in that space deserve premium pricing.  Yet, as history has shown us many times, current valuations are simply not sustainable.  Sooner or later, as it always happens, prices will reflect the fundamentals.  It could take some time, and so I would not make aggressive bets against these stocks, such as shorting or buying puts.  As John Maynard Keynes said, “Markets can remain irrational a lot longer than you and I can remain solvent”.  But eventually they will get rational.  Buyer beware.

November 16, 2010 at 5:56 pm Leave a comment

Earnings Season is Over, Now What?

The third quarter of 2010 is over, and effectively all the companies have reported their earnings. Similarly to several past quarters, they were very good. Nearly 80% of companies beat earnings estimates, and 55% beat sales expectations. Profits rose 31% year-to-year, while revenue rose 8%. The top-line growth is very important, as it shows that profitability improved from increased sales, and not only from cutting expenses.

With midterm elections over and no major news on the horizon, the market may well experience a short-term consolidation, which will not be all that surprising after the recent run-up. I don’t expect it to last very long, however; it is quite likely that the valuations will start moving up again closer to holidays in anticipation of next quarter results. Longer term, I believe that the equities are still very attractive from the fundamental point of view for several reasons.

First, the valuations are still very reasonable. Currently, S&P 500 trades at about 14 times forward earnings, which is about average for the last 60 years or so. But as always, this metric is not very meaningful in isolation. Investors always compare stocks to their closest competition, bonds. For that, earnings yield, which is simply inverse of the P/E ratio and is around 7% at the moment, is compared to bond yield. Ten-year treasury currently yields a very low 2.5%. Thus the spread between earnings yield and bond yield is near all-time high, which is very bullish for stocks. (The situation was nearly reverse in 2000, when earnings yield was 1.67% and well below bond yields).

Second, the Fed is firmly behind the recovery and as the Wall Street saying goes, “Don’t fight the Fed”. With the second round of quantitative easing (meaning that the Fed is buying bonds again), U.S. in now in the business of exporting inflation, which means low inflationary environment in the U.S. and continued depreciation of the dollar. Your next European vacation is likely to be expensive, but exporting U.S. companies in your portfolio should more than compensate for it.

Finally, economic conditions continue to improve gradually. Recent unemployment reports showed a meaningful drop in first-time claims. There are some signs of banks finally loosening their lending standards. The housing market appears to have stabilized.

With that said, at least some of the above information may already be reflected in market prices, and the consolidation I mentioned earlier is quite likely. Nevertheless, I believe that long-term uptrend remains intact.

November 12, 2010 at 8:25 pm 3 comments


Blog Author

Leon Shirman's long-term investment philosophy is summarized in his book, “42 Rules for Sensible Investing”, also available from Amazon.

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