PE RICH AND CASH POOR…

Making money in the stock market is in the data you can measure. The most used form of measurement is the Price-to-Earnings ratio (P/E ratio), but if a company’s PE was the only requirement in picking a winning stock, everyone would be rich. 

Price-to-earnings or PE is what some market participants use to determine if a stock is overvalued or undervalued. But the question is…how reliable is PE as a form of measurement? And what are the parameters used to determine the value of a company, based on PE? 

Most start by looking at the competing company’s PE and gaining a competitive perspective, based on the average PE for companies in that particular sector.

Some compare companies to the historic PE as a benchmark, using the S&P 500 and the Dow Jones. Depending on the period, the PE for both indexes varies between 15 to 20 with the averages at about 16 times earnings. 

To frame it, one should think of PE as a multiplier that suggests how much an investor is willing to pay for each $1 in earnings. 

So, if XYZ earns 2 dollars a share annually and it’s trading with a PE of 20, this means it’s trading at 20 times earnings or 40 dollars a share. In many cases, this will be considered expensive based on the index’s benchmark averages of 16 times earnings. 

The whole idea around PE is value. A company with a low PE and stable or growing earnings may be considered undervalued. Conversely, a company with a high PE and slow earnings growth may be considered overvalued. 

So, an essential factor in PE expansion is growth and a company’s ability to grow earnings on a consistent basis.

As simple as this sounds, valuation becomes stretched during a bullish period. This is where we see PE expansion where the market takes into account—growth, as a major element to determine the value of a company, which impacts the PE to the upside.

Meaning…what was considered outrageous in a bearish market during a period of PE contraction—is now status quo in a bull market, which is contradictory if you stay steadfast to the benchmark PE of the indexes. Or you take a sector like Tech, which has a history of PE expansion and high growth, with the promises of higher earnings in the future. 

Simply put, if investors are willing to accept a higher PE in exchange for high revenue and earnings growth. The market will push the limits of PE to the outer bounds.

For instance, during the pandemic Tesla traded with a four-digit PE at a time when their growth rate was just 28%, it was the hype surrounding their electric car growth and the expectation of Tesla turning cash-flow positive in the 4th quarter of 2020 that fueled the stock’s take-off.

In 2020, Tesla ran 743%; the PE was nonexistent in 2020 because Tesla had negative free cash flow. But if you turned to January after going positive in the 4th quarter, the PE was over 1400 (or about 46 times the PE of the current S&P’s 30.75 times earnings, and 87 times the benchmark historical average PE of 16).

The real question is - what makes a market run a company up 743% in the hopes of turning a profit? And when is it ever justified? There is not an analyst in the world that would get caught dead starting a strong buy on a company with a PE of 1400— at least not one you can take seriously. 

So, you might be curious as to how a stock runs 743% in one year without earnings. 

It’s a combination of high expectations and irrational exuberance. Need I remind you that Wall Street is filled with chasers and sheep. And it’s one thing to be prudent, but it’s a totally different thing to be left off the FOMO train.

You can always justify selling a stock when it goes down, but it’s harder to justify keeping your job or money under management when everyone owns the biggest winner of the year, and you don’t.

This is why approximately 70% to 80% of analysts had a buy rating on Tesla in 2020. This scenario is reminiscent of window dressing, where institutions sell their losers in a quarter and buy the winners in the quarter, giving the appearance they were in-the-know and on the inside track.

PE can also be an indicator that the market is at its low or peak. 

Historically, since 1933 whenever the S&P 500’s PE breached 20 times earnings, the S&P 500 had a sell-off within 1 year to 3 years later.

Wall Street has projected that the S&P 500 will earn 275.24 in 2025. So, if you divide the current S&P 500 6060.50 by the 2025 estimates of 275.24, the S&P 500 will be trading with a forward multiple of 22.01 times earnings.

The current S&P 500 PE of 30.75 indicates that we could see a downturn within the next three years.

Even The Buffett Indicator is screaming that the market is at a level where we are playing with fire. (The Buffet Indicator is calculated by dividing the Wilshire 5000 index by the gross domestic product). The Buffet Indicator is considered to be around 70% to 100%; readings above 100% indicate the market may be overvalued. The current reading is 208%, which explains why Warren Buffet is sitting in $325 billion in cash.

AN UNINFORMED DOLLAR IS A BURNING DOLLAR…

When you understand the future value of money, you develop a deep sense of urgency to outpace inflation. The Consumer Price Index (CPI) is an important gauge of inflation. The current rate of inflation is 2.7%.

In June 2022, inflation peaked at 9.1% - a long way from our current state. The Federal Reserve’s dual mandate dictates stable pricing, low unemployment, and low inflation. Their target is 2% inflation. 

Now let’s opine on real inflation and the compounded effect that has been cleverly tucked under our noses. 

Real inflation is the actual increase in the cost of living experienced by the ordinary person, you and me. While the Feds are pushing the doctrine of 2% as an acceptable rate of inflation, let’s talk about something as basic as a carton of cigarettes. 

In the 1980’s, a carton of cigarettes was 10 to 12 dollars a box. The cost to make that carton of cigarettes was approximately one to three dollars. 

Today, the same carton alone costs around two to three dollars to make, but the price for a carton of cigarettes has skyrocketed between 80 to 100 dollars, or 1000 percent depending on the brand. Is this an example of real inflation or corporate greed? 

Granted, the cost of living and production has gone way up, but have they increased 1000% percent? That is the question. 

Look at eggs; in the 80s you could buy a carton of eggs for 99 cents. Today, depending on the type of eggs and where you live, they can range as high as 3 to 10 dollars.

Regardless of the cost to produce the eggs, consumers have been paying exponentially more for goods and services over the years. 

Think about what 250 dollars did for groceries back in the 80s; you walked out of the store with a full cart or almost two. 250 dollars had a buying power of approximately 958 dollars in 1980. 

Today, that same 250 dollars is worth 258 dollars that’s a decrease in buying power of 75%. Now tack on 2.7% inflation and you’re lucky if you get four bags of groceries today. 

This is a discussion that needs to be had out loud across America, because people are feeling it in private. The fact is - people are in a race with the devil and the devil is driving a fire red Ferrari, while we are running on a treadmill, and inflation is burning our money in a 16-alarm fire.

How will people ever retire if the dollar they are making today is not only an uninformed dollar but an underperforming dollar—a dollar that’s not being invested? And even if it is, it’s not at an optimum rate, that can only be achieved by financial literacy and education. 

This dollar is being spent without the inside information that if you spend frivolously today you die without it tomorrow.

One thing is certain, you can’t outspend inflation, you can only out-invest inflation. The fact is, if you don’t have a plan for your money someone will. So, if inflation wasn’t the biggest threat to your money, it is now.

The distractions are even greater. Between the combination of social media, media in general, and the nonstop bombardment of advertisements, there is a battle being instigated—between your wants and needs, and social media; media, and all news mediums are the financiers.

For every dollar that’s being generated, there is an equal or greater need or want being enticed, so that you consume an associated product based on how they made you feel. 

After all, that’s what consumers do - as if we are prized cattle and our money is the milk that feeds corporate greed.

We are in a crucial conflict between having a life, living versus lifestyle, and which particular brand is being sold. All of this - while our quality of life is deteriorating, like farmed tilapia swimming in its own feces, being packaged as responsibly raised. 

Our family’s stabilities are at risk and the family structure has been neutralized. We are both at war with others, ourselves, and our money. My dad used to say Move it or lose it. So, it’s only right I rebrand it and say Get your money a job or be on the job for the rest of your life.

The first thing you need to come to terms with is that you need to outpace inflation. The second is to understand the reflex and consistency you need to achieve it. The third is to understand the vehicles that can get you there. 

Let’s start with compound interest.

To society, this has become the Illuminati of numbers. When simply put, it’s a way of multiplying your money as it grows on a consistent basis over time. 

Now it’s a known fact that most Americans don’t have a financial education. So why be a genius and try to pick a winner from the shelves of hearsay and the latest and greatest widget factory? 

How about you work what works? If I had no experience or a clue, I would buy an S&P 500 vehicle like the VOO or the VOOG. Here’s why.

The S&P 500 has returned 10.6% over the last 100 years, historically, but it has a .09% expense ratio. 

The VOO, Vanguard’s S&P 500 ETF, which carries an expense ratio of .03%, mirrors the S&P 500. The VOO was introduced in 2010 and has averaged between 12% to 14% compounded annually. 

*This is only an illustration based on the 100-year returns of the S&P 500 average of 10.6%

The Vanguard VOOG, which tracks the fastest-growing companies in the S&P 500, and has an expense ratio of .10% was introduced in 2014 and has averaged 15% to 18%. While the tenure of both isn’t the same as the S&P 500. They have the performance - as they both track the S&P 500. 

One doesn’t have to be a genius just optimistic, that one will live to see retirement and plan accordingly with discipline filled with purpose and a commitment to pay yourself, so your family doesn’t finish last. 

SHEEP WILL BE SHEEP

I have often said, that where there is a crowd gathering there is a slaughter nearby. Often, it starts with, who is the next NVDA?…or what is the next big thing? On Wall Street we call it, pie in the sky. Or if you are legitimizing it, the next ten baggers.

Once the fire starts, it doesn’t take Wall Street long before they start jumping on the bandwagon. All it takes is one person to start running, then the crowd starts to stampede; this will continue until someone yells, stop!…what are we running for again?

But just before the air leaves the room, the bag holders, aka the retail investors, start to push the narrative of riches to come. You hear it in the barbershops, at the basketball courts, and even at the grocery stores; everyone can’t stop talking about it.

In this case, it’s quantum computing; you don’t have to go far before you hear retail investors screaming this is the next big wave…you better catch it.

How is this different from the Bitcoin craze and migration to junk coins, where a lot of retail investors got pummeled and swore off crypto like one more drink to an alcoholic? - or - Marijuana stocks like Tilray Brands Inc. and Aurora Cannabis Inc. that were the craze after Canada legalized marijuana in 2018?

The stocks roared, but between the combination of federal regulatory hurdles, oversupply, competition, and over-hyped valuations, these air balloons fell from the sky.

Now everyone’s talking about companies like Quantum Computing Inc. (QUBT), D-Wave (QBTS), IonQ (IONQ) and Rigetti (RGTI).

Here is what they all have in common:

• They all went public through SPAC’s 

• They are all losing money

• Except for IonQ, they were all penny stocks

• Annual revenues are extremely anemic, revenues don’t surpass 100 million for all 4 companies combined

As a footnote a SPAC in its original form is a Blank check corporation or Shell corporation that is used to circumvent the Initial Public Offering process by going public through a reverse merger, typically these companies don’t meet the revenue or profitability requirements to go public the traditional route.

With that being said, these types of investments are highly speculative and extremely risky and are often penny stocks, and because they are what the uneducated retail investor considers cheap, they very often find out these types of companies are cheap for a reason.

This is why the word Quantum is being passed around like a frisbee. And the Wall Street spin machine is hard at work, especially with Google’s ginormous breakthrough this week with their new, state-of-the-art quantum chip, Willow.

It was said to be able to perform a calculation in under five minutes—this would take a supercomputer 10 septillion years to complete. This breakthrough feeds the hype that it will revolutionize medicine, energy, and AI capabilities.

So, Wall Street has quantum computing in its crosshairs and it’s anyone’s race to win; with one exception; real-world applications are many years away, and so are any meaningful revenue or earnings for that matter.

But that won’t stop the headlines, like The Top 10 Hedge Funds Quantum Stocks. The fact of the matter is that, if Wall Street can push the narrative, a profit is just one transaction away.

Think about the internet craze in the dot-com era, when all you needed was a great story and a dot-com next to your company name.

Quantum computing is no different…at least Artificial Intelligence had the decency to show up with current state real-world applications, revenue, earnings, and proof for the bull-case - and even so we are way too early.

While there is absolutely no doubt that quantum computing will have its place in investment history…first, you must understand that it’s going to take many years before there are real-world use cases and a huge amount of CAPEX. 

So, if there are winners in the space it will be the companies with the fortress balance sheets, like Google, NVDA, MSFT, and AMAZON—not the negative cashflow penny stocks roaming around the rumor mills of retail Wall Street, with no revenue and no earnings.

Now on the flip side—Google is an institutional quantum trader’s wet dream. They are trading with a forward PE of 23 times earnings; it’s the cheapest of the magnificent seven. It hasn’t truly participated in the AI run because it has exhibited Intel vibes, showing up late with Gemini, which makes this ripe for institution manipulation…oops, I mean—investment.

So as an investor, one must ask…how much are you willing to pay for potential earnings that are way distant into the future? 

IN ELON WE TRUST…CAPTAIN DOGE!

So let me get this straight, because Trump won, and Elon is in his cabinet. Tesla’s bull-case investment thesis should be compounded by a factor of two. It was just two quarters ago; margins were compressed, prices were decreasing, and sales were declining. 

Just in April, Tesla reduced prices on the Model Y, S, and X. The Robotaxi event in October was underwhelming; at best, we are three years out and there is no clear date on the $25,000 car. My question is, what has changed to warrant a 100% increase in stock price and the acceptance of 100% PE expansion? In my opinion—absolutely NOTHING!!!

It’s funny how the street picks and chooses when to have financial amnesia. Tesla had one good not great quarter where margins increased to 19.8% above analysts’ expectations of 16.8% (up 17.9% a year ago).

Gross margins in the auto business were 17.1% above the forecast of 14.8% (on revenue of 25.2 billion). What sent the stock up with the unexpected profit of $2.17 billion in the 3rd Quarter vs the $1.85 billion, in the same period last year?

And while I am a Tesla investor, I have to say one quarter is not a turnaround make. Are we investing in the data that matters and are we to expect consistency and execution from here on out to justify a current multiple of 114 times earnings and a forward PE of 97—or—are we expected to invest in the speculation of favorable FSD (Full Self Driving) regulation now that he is in government? I am asking for a friend.

The stock has been up 100% since August. Either this is a case of Where there is smoke there’s fire or this is the most historic case of crony capitalism, with lobbyist vibes we have ever seen. Elon Musk spent $270 million for his Trump Bump. As an investor, I love it. But as a fundamentalist, I must ask…does the stock price represent the present state of the business or the speculation of what’s to come?

Whatever the answer may be, Wall Street applauded Elon and rewarded him for his efforts to assist Trump’s win, with the richest man in the world moniker again.

The ironic nature of this is that Tesla has had six consecutive quarters of turbulence and one-quarter of stability, and the stock skyrockets as if they are back in their 50% a year growth trajectory.

To be fair, we could see a case of over deliver and under promise, which by the way would be a first. So, if we do get FSD approval in 2025, a delivery date on the $25k car, and consistent margin expansion in the energy business, we could see some fireworks, but don’t hold your breath; Elon makes promises like a fentanyl fiend…

QUICK LINKS…

Trump is the official president of deregulation - 1 billion will buy you….

The Street says 98% chance of a Fed Cut on the 18th - Could this spell inflation?…

Tom Lee a CNBC contributor says Bitcoin in 2025 could go as high as …..

QUICK QUESTION…

We would love your feedback… what topics would you like us to cover in future Newsletters?….Email or comment with your responses…

BOOK OF THE WEEK- A RANDOM WALK DOWN WALL STREET, by Burton G. Malkiel

Thank you for reading and again please like, comment, and share with your tribe and follow me on Facebook, Instagram, and Tiktok 

Kevin Davis Founder of Investment Dojo and Author of The C.R.E.A.M. Report