Sunday, May 26

Month 95 - Dow Jones Industrial Average - Spring 2019 Update

Situation: The S&P 500 Index has recently posted a new all-time high, and “The Dow” is only 1% away from a new all-time high. However, Dow Theory won’t label that achievement (if it happens) as the beginning of a new Primary Uptrend. Why? Because the Dow Jones Transportation Average still has to go somewhat higher before it “corroborates The Dow.” Conclusion: Dow Theory still places the US stock market in a Short-term Downtrend. If you’re a stock-picker, that means you still need to consider selling the overpriced stocks in your portfolio. Why? Because things are likely to get worse before they get better.

Mission: Use our Standard Spreadsheet to highlight DJIA stocks that appear to be overpriced.

Execution: see Table.

Administration: It is almost impossible to distinguish an overpriced stock from a stock that is pulling in more investors because they see a bright future. If the company is already highly regarded because of its Balance Sheet, Product Lines, and Brand Penetration, I would hesitate to call its stock overpriced at any P/E (think of Amazon with its P/E of 81). 

I’m a numbers guy, so I use two numbers to decide if a stock is overpriced (where “price” or P is defined as the 50-day moving average):
   1) the 7-yr P/E is greater than 30. 
   2) the stock’s Graham Number, which is the square root of 22.5 times Earnings Per Share multiplied by Book Value Per Share, is more than 250% of its price. 

If only one of those two numbers is over the limit, the stock is still overpriced if the other number is close to the limit, i.e., more than 25 or 200%, respectively. (For Amazon, those numbers are 53 and 752%. So, it’s overpriced and I sold my shares.)

Deciding whether or not to buy a stock is also tricky. To give a more nuanced estimate of a stock’s value to the investor, I’ve devised a Basic Quality Screen that has only 6 elements and a maximum score of 4 (see Table): 
   1) If price appreciation over the past 16 yrs has been greater than 1/3rd the risk of short-term loss as determined by the BMW Method, one point is added. In other words, price appreciation in Column K is greater than 1/3rd the risk in Column M.
   2) If Tangible Book Value in Column S is negative and LT-debt represents more than 50% of Total Capital (Column O), or Total Debt is more than 250% of EBITDA (Column P), one point is subtracted.
   3) If the S&P Bond Rating in Column U is BBB+ or better, one point is added. 
   4) If the S&P Stock Rating in Column V is B+/M or better, one point is added. 
   5) If Net Present Value of accumulated dividends and cash-out after a 10 year Holding Period is a positive number, when applying a Discount Rate of 10% (see Column Z), one point is added. 
   6) If the two markers of an overpriced stock noted above (see Columns AB and AD) indicate that the stock is indeed overpriced, half a point is subtracted.

The final SCORE is found in Column AJ.

Bottom Line: How to sell a stock is always harder to learn than how to buy a stock. The 30 stocks in the Dow Jones Industrial Average are great companies. So, those are even harder to abandon once you’ve seen the way their stocks perform in your portfolio. And, the prominence of these companies in the press is guaranteed to attract investors who don’t think they need to do their own due diligence before adding stock in a famous company to their portfolio. You see the problem: We have here the makings of a Perfect Storm that will hit someday. 

Conclusion: There are 11 Dow stocks that appear to be overpriced now: MRK, MSFT, V, NKE, BA, UNH, MCD, KO, HD, JNJ and MMM. And, even though the stock market is generally thought to be overpriced, an equal number appear reasonably priced (see Column AJ in the Table): PFE, CSCO, DIS, AAPL, INTC, PG, TRV, JPM, WMT, CAT and UTX.

Risk Rating: 6 (where 1 = 10-yr US Treasury Notes, 5 = S&P 500 Index, and 10 = Gold bullion).

Full Disclosure: I dollar-average into MSFT, NKE, BA, INTC, KO, PG, JNJ, JPM and CAT, and also own shares of PFE, CSCO, MCD, AAPL, TRV, WMT, MMM, XOM and IBM. (All dividends are automatically reinvested.) 

My holdings of stock in those 18 “Dow” companies are meant to represent a cross-section of the US economy. But you shouldn’t think my future returns (adjusted for risk, transaction costs, and capital gains taxes) will beat The Dow. Only a full-time trader has better than a one in twenty chance of beating the Dow Jones Industrial Average over the next two market cycles. And that trader will likely find it necessary to buy and sell stock options (so as to protect large positions from market-turning events). She might also minimize transaction costs by working from a Globex Terminal, meaning her trades are guaranteed by a firm with Globex Registration at the Chicago Board of Trade.

The rational basis for us, as retail investors, to buy shares of stock in specific companies is to have a growing stream of Dividend Income during retirement years, while leaving Principal intact, i.e., the shares that generate those dividends would only be sold to handle a severe financial emergency. 

P.S.: Warren Buffett advises his friends and family to invest 90% of their savings in a low-cost S&P 500 Index fund marketed by the Vanguard Group , such as VFIAX.

NOTE: This text was written on 5/6/2019.

"The 2 and 8 Club" (CR) 2017 Invest Tune All rights reserved.

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