Market Valuations, Energy Stocks, Greece, and Gold Mike Swanson (12/07/14)

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1 Market Valuations, Energy Stocks, Greece, and Gold Mike Swanson (12/07/14) There is a big problem with oil stocks right now. Oil broke below $70 a barrel the other week and oil stocks crashed. They look to me to be in the same position that gold stocks were in back in On a daily basis there seems to be one blowing up and crashing. The other day Canadian Oil Sands announced that it was cutting its dividend and it dumped. Other oil trusts fell as a result too. PGH was one that crashed. Now inside the energy market commercial traders built a record short position in the summer. So they positioned themselves ahead of the oil drop. There is no doubt that they saw it coming. How far will oil prices drop? I have no idea. There is talk of $40 a barrel and talk that maybe $60 will hold. What I do know is that oil stocks have a much bigger problem then simply falling oil prices. Even if the price of oil stays above $60 the oil stocks are likely to just continue to dump over the next several months anyway. Look at mining stocks. Gold only fell down to $1,130 an ounce last month and mining stocks crashed. But oil stocks are actually in a worse position than gold stocks were a few months ago. What is wrong with them? Think about the stock market for a minute. If you talk to people about the US stock market right now you get essentially two arguments that are a bit different from what people were saying just six months ago. On one hand you have the average investor who really knows absolutely nothing about investing or trading or managing money. This type of person simply buys into a market when it has gone up for a long time and they start to fear missing out and they sell after crashes. They simply chase news stories and are merely a part of the crowd. When they get bullish they just repeat the arguments that they hear on TV for why the market will go up. The other type of market player is the professional trader. He is the Wall Street type you see on your television screen. He too is a part of

2 2 the crowd, but his or her arguments tend to be different than what the masses say. I can tell you that the professionals I talk to that are bullish on the stock market believe either one or two things. They think that the Fed is going to make the stock market go up forever and therefore valuations do not matter or else they think that we are at the end of the bull market and are hoping for a final big bubble blast-off. They see the sector deterioration and the narrowing leadership in the market, but believe that the market is going to continue higher for a bit anyway in some sort of final blow-off rally. Most of these people play pure momentum and do not care about fundamentals and valuations. They also must be in the market if they are managing money for people, because if they miss out on a market rally their clients will take their money away from them and they will be out of a job. They cannot be cautious and protect people s money, because that is not what people really want, because people as a whole fear missing out more than they do losing so the professional money manager is forced to manage people s money accordingly. Instead of admitting to themselves that this is risky though they tend to get caught up in the bullish sentiment and look for reasons to believe that the market is going to continue to go up. Everyone wants to convince themselves that they are right. What is interesting to me is right now such people are simply arguing that the Fed will step in if the market drops and that the market is just taking off and that is why you must buy into it now. This is much different than what people were arguing six months ago or even twelve months ago. Back then the professional you would talk to or see on TV would argue that yes the stock market is overvalued, but valuations do not matter, because interest rates are zero. Since interest rates are zero stocks that pay dividends are worth much more than traditional valuations would suggest. This thinking process led to big rallies in safe dividend paying stocks in the DOW and S&P 500. Think about stocks such as JNJ for example.

3 3 Energy stocks are also a sector that pays nice dividends and energy stocks exploded in value starting in 2012 even though the price of oil did not go up much since then. Take a look at the two charts on the right to see what I mean. The top one is the XLE energy stock ETF and the one below is the price of oil. You can see that oil prices basically went sideways since 2012 until their recent breakdown while the XLE energy stock ETF went up at a 45 degree angle just like the US stock market did. The people buying energy stocks were buying them for the dividends. They chased the stocks up so much that many of them became incredibly overvalued. Exxon for example right now is trading at a PEG ratio of 3 and 91 times revenue per share. Chevron has a PEG of 2 and trades at 107 times revenue. For comparison sakes the bubble stock FB trades at 4 times revenue. A PEG ratio of one is considered to be fairly valued and I like to look for PEG ratios of 0.50 to find bargains. A PEG ratio looks at the price you are paying for future earnings growth so low pegs are a way to find stocks cheap from a value investing standpoint and with high earnings growth to boot. Right now with the recent decline in energy stocks the sector is trading at a CAPE ratio of 13.60, which is roughly around its mean valuation overall. But sectors can get super cheap after a bear cycle plays out and energy stocks are not cheap right now. At best the sector is at a mean valuation with bubble valuations in the biggest market cap stocks in it. These are the stocks that everyone knows and everyone bought from 2012 until this summer on the basis that valuations do not matter when it comes to dividend paying stocks, because interest rates are zero. Those people who bought energy stocks on that basis are now getting crushed and will continue to be hurt in the coming months. The real problem with energy stocks right now is not falling oil prices, but the crazy prices that people were willing to pay to buy them. You see energy stocks became something of a bubble and therefore can fall a long ways over the next twelve months even if oil prices stay above $60 a barrel. When a

4 4 sector reaches a high valuation and then falls into a bear market it can fall so much that it takes people by surprise. Valuations can get super cheap just as they can get super high. Just look at what gold stocks did since Energy prices and energy stocks are just now starting a stage four bear market that is likely to last for a year and maybe even two years. Now I think this will make for a wonderful investment opportunity. I bought in European markets in 2012 and make some nice money in them, but I first talked about looking at them in 2011 as they were declining. I like to look ahead for opportunities instead of just chase the fad of the moment. So energy stocks are something I m looking forward to investing in after this bear cycle in them plays out. The way I play the markets has changed since when I first got into the stock market in the late 1990 s. Back then I simply looked at charts and did not look at fundamentals at all just as most of the Fast Money players do today. I did that though not because I thought the market was going to go up forever, but because I new it was a bubble that would end one day and the stocks I was playing were internet stocks. I did not buy and hold these stocks, but would play them for 2-5 day swings typically. I was essentially a daytrader. Then I started to play for trends that could last for months. Then as time went on I looked to play trends that would last for even longer and became more of a real investor. Today I look to invest in sectors and markets after they have gone through a bear market that has brought them super low valuations. Then I can buy with the hopes of holding for several years with the prospect of making giant gains. This is why right now I have talked so much about metals and mining stocks. It is why I m talking about oil as a future investment opportunity. And why I ll mention another market in a moment. I believe that this is the easiest way to make big gains in the financial markets over time. However, it is not how most people play the markets at all. The problem is the US stock market has gone up for five years and is late in a bull market and is now at a crazy valuation level

5 so it makes no sense to buy and hold it from an investment standpoint of several years. There simply are better opportunities to do that elsewhere and the risks everyday are simply growing in the US stock market. The problem is that the US stock market is all the TV talks about so that is all most people think about. But there is a lesson from what has happened in oil stocks. This was a sector a year ago that seemed to be safe and make perfect sense and now it is in a bear cycle. I look at that as an eventual opportunity, but it is also a giant warning of what can happen to many sectors in the US stock market. The US stock market as a whole is overvalued and that puts it in a risky position to fall one day just like energy stocks have done. The simplest way to look at the valuations in the market is to use the cyclically adjusted P/E. Warren Buffett s mentor Benjamin Graham pointed out decades ago that using the simple P/E average doesn t work too well when looking at stock valuations, because of the year to year volatility that impacts them. As a result he recommended averaging out earnings over ten years to see what the valuation really is. Robert Schiller came up with the CAPE ratio to do just that. It takes a look at the ten year P/E and adjusts it for inflation. If you divide up the S&P 500 into 11 sectors here are the current valuations by CAPE: 5 Sector N0. of stocks CAPE RATIO Energy Financial Services Utilities Consumer Defensive Industrials Basic Materials Communication Services Consumer Cyclical Technology Healthcare Real Estate S&P

6 6 Here is the historic CAPE ratio for the US stock market. The level of has been it s historical median. It s currently at so one way to look at it is to say that the market is currently 72% overvalued. Another way to look at it is to say that it has gotten higher than this before. It reached a higher valuation in 1929 and in 2000 too when it got all of the way up to The professionals currently bullish on the stock market experienced a once in a lifetime bubble blow off rally in 1999 and 2000 and are expecting it to happen again for them. This is what they are betting on and they also believe that the Fed will make it happen for them no matter what harm it may mean for the country as a whole once it bursts. Some of them simply believe that they are entitled to another bubble for their loyalty to the Fed and government action just as some people feel entitled to food stamps and unemployment benefits. The Fed bailed out Wall Street banks so it should make stocks go up forever is the way they think. The reality is last week the US stock market reached a milestone when the CAPE for the S&P 500 surpassed the highest level it reached in 2007 at the top of that last bull market. So the only time it has been higher has indeed been in 2000 and I know most people do not care about valuations. For most people investing consists in merely buying and believing. Trading and momentum playing for a few weeks is one thing, but true investing consists in buying stocks where valuations are cheap.

7 7 It s not just the CAPE ratio that is flashing a warning sign. By any other indicator the US stock market is overvalued. One indicator is the market cap to GDP of the US stock market. Take a look at it above. Data comes from the Federal Reserve. This is not all to suggest that the stock market is going to crash tomorrow or next week. I think we are in the process of going through a stage three top that will likely be complete in the coming months. Stage three tops are typified by a narrowing in the leadership in the market and many sectors and stocks actually going into bear markets ahead of the stock market averages. The process started this summer and picked up steam during the October drop. But the market is now in a rally mode. We may get a dip, but no real big end to the current rally until next year. What it is to suggest is that if you are looking to buy something that you can expect to hold for several years and make big returns you are best to look outside of the US stock market. I believe one such place is metals and mining stocks, but there are also some other opportunities.

8 8 Let s take a look at the valuations of world markets. You have an entire mix of asset classes and world market that you can invest in. Take a look at the table on the right. These are most of the major world markets ranked by valuation. Historically the lower the CAPE ratio is when you invest the more you can expect to make in the next three years and the higher the CAPE ratio when you invest the less you can expect to make and the more risk you actually take on. Simple logic suggests than if you want to buy and hold with a time frame of several years than you want to avoid the US stock market now and look towards cheaper markets. Country CAPE Greece 2.7 Russia 5.2 Hungary 5.6 Austria 6.8 Portugal 7.3 Italy 9 Ireland 9.5 Brazil 9.8 Czech 10.2 Poland 10.6 Spain 11 Turkey 11.5 Norway 12.1 United Kingdom 12.3 Korea (South) 12.7 Singapore 13.4 France 13.5 Finland 14 Belgium 14.2 New Zealand 14.2 Israel 14.6 Netherlands 15 Germany 16.1 Australia 16.5 China 17.2 Thailand 17.7 Hong Kong 19 Taiwan 19.1 Canada 19.2 Sweden 19.5 Malaysia 20 India 20.8 South Africa 21.4 Mexico 22.7 Switzerland 22.8 Japan 24.6 Indonesia 26 United States 27.2 Denmark 31.4 The cheapest markets in the world are Greece, Russia, Hungary, and Austria. Argentina and Ireland are also super cheap. Now low valuations usually come after vicious bear markets and during times of bad news and economic turmoil. The US stock market reached a CAPE ratio of around 4 during the stock market bottom of the Great Depression. People who read the news would have been too scared to invest and

9 9 everyone would have talked you out of investing then, because of the brutal losses in the stock market that came before the bottom if you could turn go back to that moment in time with a magic time machine. We can t do that. But we can look at the cheapest markets today. Among them are Greece and Russia. Take a look at RSX, the ETF for the Russian stock market. You can see that it broke down the other week to a new low. It last made a peak in Of course the news on American TV surrounding Russia is very negative right now due to the Ukraine crisis and the sanctions Obama has placed on Russia to get a new Cold War game going. Russia s economy is also closely linked to the energy sector and economists expect it to go into a recession next year. I think it likely that the Russian stock market will remain weak for a few months and maybe a year along with the energy complex, but at some point it will become a compelling buy from an investment standpoint. So it is another opportunity I am watching for the future. The Greek stock market though I think looks good. You can see the Athens stock exchange index on the right and the GREK Greece ETF right below it. From 2007 to the summer of 2012 the Greek stock market went into a depression type bear market that culminated with the financial crisis in that country two years ago that was all over the news for a few months. I bought GREK and several Greek stocks after that summer bottom, with my purchase of GREK around $ I sold this February though, but I bought it back last week. We saw GREK and many other world markets dip hard over the sum-

10 10 mer and into October, but it is now basing and looks like it is about to turn up to me. If you look at it you can see that it has been in a bull market phase since 2012 and simply had a pause this year within a large bull market. And it is still at a depression era valuation so it should have lots of upside in the next few years. It s economy contracted during the past six years, but is now swinging into positive growth. In other words it s depression has just made a trough. It has grown in the past six months and is expected to grow in The Wall Street Journal reports that, According to figures from the Hellenic Statistical Authority, or Elstat, gross domestic product in the third quarter rose 1.7% from a year earlier, thanks in large measure to a record summer tourism season. The figures were better than expectations making Greece one of the fastest-growing economies in the eurozone and confirm that a promised recovery is now under way. Economists had forecast between 1% and 1.4% growth compared with a year ago. On a seasonally adjusted basis, Greece s GDP rose 0.7% quarter-on-quarter. It s still a tough economy for people. The unemployment rate is still higher than 20% in Greece and it will take time for the economic growth to turn into some sort of boom, but the economy has yet to boom in the United States either since 2008 and yet it s stock market has gone up for five years. The reality is that bull markets do not start because all of the sudden bad news ends and good news begins, but because the bear market is over and buyers take control. Cheap valuations bring in bargain buying. That is why the stock market in Greece went up in 2012 after it put in a crash bottom. And it is why stocks there are still attractive. Last week I bought National Bank of Greece, which trades on the NYSE under the symbol NBG. It is trading with a P/E of 3.79 and a PEG ratio of It s also trading a 3/4 s of book value. Bank stocks tend to lag after a bear market bottom following a financial crisis and then assert leadership much later. NBG was recapitalized last year and actually has over $3.60 in cash per share for a low debt to equity ratio. Analysts expect its earnings to grow over 175% on average per year over the next five years, so it is a cheaply priced growth stock. That s why it has such a low PEG ratio. Billionaire Wilbur Ross and a group of investors have reportedly purchased half a billion shares of stock in Greek banks. Several years ago he bought the Bank of Ireland around ten cents a share.

11 11 Shares of NBG are currently trading with support at $2.25 and resistance at $2.50. If it breaks $2.50 it will go through a downtrend resistance line that has acted as resistance since April and begin a new uptrend that will likely take it up to at least its long-term 200-day moving average, which is currently at $3.60, but I really see it as a good long-term investment in this position. As for mining stocks at the moment they are trading in a shortterm range with resistance at 180 on the HUI mining stock index and support above 160. You can see the short-term action on the 60-minute chart on the right. We should get a bounce this week off of support and move back up. Once the HUI closes above 180 we should see another nice big run begin. Last week we saw gold fall before the open on Monday down to $1,140 an ounce and then rally back up above $1,200 an ounce. That move down and rally was essentially a double bottom off of its low around $1,130 in October. Now gold dipped down a little bit below $1,200 an ounce at the end of last week. It looks to me like it is simply consolidating around the $1,200 level along with the mining stocks. All of this represents a simple sideways bottoming formation off the November lows. Gold right now has resistance at $1,220 an

12 ounce. That represents not only the area of it s recent high made last week, but also a downtrend line going back to last July. The small player is still heavily short in the gold futures market and I m sure some of them will cover their short positions once gold goes through the high of last week. I still think that the simplest way to play the gold trend is to hold a core position in mining stock ETF s and then average into individual stocks in the sector over time. One junior mining stock that I own and recommend is ATY which trades on the Vancouver Stock Exchange. ATY is the symbol for Atico Mining. It s currently trading at 62 cents a share. Atico Mining is a small cap junior company with a market capitalization of around $60 million. It's a small cap stock that has high earnings growth potential with a super cheap valuation. The company owns the El Roble Mine in Colombia. This property is the site of an operating underground copper and gold mine with nominal capacity of 400 tonnes per day. Off on and over the past 22 years the mine has processed 1.5 million tonnes of ore at an average grade of 2.5% copper and an estimated 2.5 g/t gold. Atico's underground drilling has discovered additional high-grade mineralization below level 2000, the deposit remains open at depth and strike. Atico owns a 90% interest in the El Roble Mine and began to put it into production in the first quarter of this year. It has enough money in the bank from previous financings to put it into full production by the end of this year and they are on track to do it. Analysts project that this accomplishment will earn Atico 2 cents a share in profit earnings this year and a full 6 to 17 cents a share in earnings in That means Atico is currently trading with a forward P/E between 5 and 10. Atico management plans to do more drilling and exploration around the mine and has the potential to boost the value of this property, because it has already identified and mapped a ten kilometer stragraphic contact between basalt flow and pelagic sediments and control mineralization. By the end of the year the profits from Roble will enable Atico to become cash flow positive. The company management hopes to do more deals in the future to put more mining operations into production and become a mid-tier producer by purchasing more private mid-size mines or public small-scale mines with high exploration potential. I have found in gold bull markets that the small cap stocks that go up the most are the ones that are about to increase production and are trading at a cheap valuation. The high earnings growth can cause a big 12

13 13 increase in share prices. The thing is the analyst projections for the earnings growth in mining stocks such as Atico do not factor in higher gold prices. That's why these small cap stocks have the potential to go up so much. I only put a small amount of money in these type of positions, because they are more speculative. They are small caps so you cannot really use stop loss orders on them or trade in and out of them. ATY held up relatively well this year during the big drop in mining stocks and is still well above it high s of 2013, never having gone through them. It is currently trading with support at 60 cents and resistance at 70 cents. Once it goes through 70 cents a share I expect it to easily go up to its 2014 high of 85 cents a share and then beyond as more money eventually flows into gold and mining stocks. Once gold closes above $1,220 an ounce I fully expect to see some buying panic from short-sellers begin.

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