Recently a potential exception to this rule has surfaced.  The mortgage companies were making money like crazy during the real estate boom of a few years ago.  They consciously decided to take higher risks in exchange for higher returns.  For a while they were printing money.  Someone walked in the door, all they needed was a signature and money flowed in.  Lots of money.  Billions of dollars.

Now that we are in a real estate bust, these high risk investments are not performing so well.  Lehman Brothers is in bankruptcy.  Other financial companies are on the brink.  They knew the risks.  The reaped the rewards for a while.  And now they are asking for a handout from the Government at the taxpayers’ expense in the name of improving the economy?  When did raising taxes ever stimulate the economy?

If the Government is going to make handouts to everyone that loses money on a risky venture, they should start by mailing checks to dot com investors, handing out hundred dollar bills in Vegas and reimbursing lottery ticket prices.

Let all the finance companies go bankrupt!  It won’t kill the economy.  Some foreign investors will come in and buy my mortgage note at a discount.  I don’t care if my mortgage check goes to Chino, CA or the Republic of China.  The bottom line is the same.

There is some substance to technical analysis.  Here is why:

1- Self-Fulfilling Prophecy: When people expect something to happen, it can make it happen.  For example, if the price of a stock goes above a critical moving average, technically a buy signal is generated and people buy it.  The sheer process of people buying it pushes up the price.  Note that buying can happen automatically with software that is preprogrammed to look for buying signals, which can cause extreme price fluctuations if the software algorithms get in a positive feedback loop (e.g. price went up buy, price went up some more – buy more, etc.).

2- Emotional Predictability: The emotions of people have predictable element to them.  For example, if many people buy a stock at a particular price, and the stock drops dramatically, the stock will have a hard time to get above that price again.  This is called price resistance.  Why?  Because people hold onto the stock until they can get even.  Once it reaches the price again, a lot of people sell the stock driving it down.

3- Insider Trading: Although illegal, inside information can cause a stock to go up or down as people are tipped off about an upcoming press release.  This can create technical buy or sell signals.

Technical analysis is an art, not a science.  Once a particular technique is discovered it can lose its effectiveness.  There are too many factors to consider to be sure.  It is a game of anticipating what the other investors will anticipate that the other investors will anticipate.  In some cases there can be statistical significance in following technical indicators.

Technical analysis is nearly the antithesis of fundamental analysis.  Fundamental traders will wait for the price of a stock to go down and buy it because it appears cheap.  Technical traders will wait for the price of a stock to go up indicating that it will go up some more.  Common sense should be considered in both cases.  There should be a reason beyond pure fundamental or technical considerations when investing.

Are they a good deal now?  That depends – you need to do your research. Are they a better deal than yesterday? You better believe it.

Although earnings or the bottom line is the most important, sales tend to be a good indicator of earnings.  The only way a company can grow its earnings is to sell more or increase the profit margin. 

Sales are not as easy to manipulate through creative accounting as earnings are, so the PSR may be a more objective indicator.  In a strong bear market, a selection of high PSR stocks can make a nice portfolio of investments to short.

For example, the expression, “Don’t try to catch a falling knife” means if the price of a stock is declining sharply, don’t buy it.  A “dead cat bounce” is a price increase after a sharp decline due most likely to speculators trying to guess the bottom.  “Trading sideways” means the price has been in a stable range for a while.

“No tree grows to the sky” means that a company cannot grow indefinitely.  As Warren Buffet has found out, when a company gets very large, it’s hard to grow it at a fast rate, even if you’re the smartest investor in the world.

To “go long” means you are bullish on a particular investment.  You purchase a stock through your brokerage for example and hope the stock goes up in value so it may be sold at a higher price, i.e. buy low, sell high.

To “go short” means you are bearish on a particular investment.  You borrow a stock from your brokerage for example, sell it and hope the stock goes down in value so it may be purchased at a lower price and returned to the broker, i.e. sell high, buy low.

Some speculate that shorting stocks is riskier than buying stocks on the basis that there is no hypothetical limit to the loss you can experience if the price of a shorted stock goes to infinity, where a long position can only lose you your original investment.  I’ll believe this theory when I see a stock go to infinity, however, the associated risks should always be considered when investing in either direction.

The PE ratio is the current price of a stock divided by the earnings per share of the stock over the last year.  The PE ratio actually makes more sense if you invert it (divide the earnings by the price).  This is called the earnings yield.  A stock with a PE of 15 for example has an earnings yield of 1/15 or 6.7%.  In other words, every dollar worth of stock has paid out a return of 6.7% in earnings.  Is that good?

Well, lets say the 10-year bond has a yield of 3.9%.  Since a stock is riskier than a government bond, you should look for about twice the yield or 7.8% (or PE ratio of no more than 12.8).  So an earnings yield of 6.7% is not so hot, in theory.

The uselessness of a PE ratio is twofold.  First, it is based on past not future earnings.  Second, the earnings may not be real earnings.

For example, lets say a stock has a PE ratio of 1.  A great deal?  Not if the earnings are going to change from $10 a share to $0.01 a share over the next year.  Let’s say a stock has a PE ratio of 1000.  Expensive stock?  Not if the earnings are going to change from $0.01 a share to $10 a share over the next year.  What if the earnings are a result of “creative accounting” like pilfering the pension fund, or excluding massive amounts of stock options?

The PE ratio by itself will not tell you if a stock is a good buy.  You need to do a lot more research to figure that out.

Research. Hard work. This is the edge. There is no magic formula. There are several indicators, the combination of which will help you outperform the market.