Monday, May 24, 2010

BACK TO THE FUTURE- A Look at Relative P/E and Return on Equity

The market hates uncertainty.  I used to teach new traders pricing options to make people pay for their uncertainty.  When the markets swoon, traders are making people pay (volatility premiums go up as they should in these conditions) and buyers are hitting the exits.  We have seen this in droves the last couple of weeks.  Most of the news surrounding the markets has had little to do with what companies are doing and the money they are making.  The markets need more decisive action by the Euro governments and seem to be getting it as of this morning.  So there is a bit less uncertainty.  The best way to make some money from all this noise is to add a little more here.  It might be unpalatable but the pricing is much better because so much worry is already priced in.

As I write this post of Friday the 21st, the SPX is up a bit, 3pts and the VIX is down a bit, 3 pts.  The market is about where it was after the panicky sell off on Thursday.  With this correction being compared to 2008 (Will it happen again?), I thought it would be instructive to include the 2008 Meltdown in a comparison of the Price Earnings Ratios of today with the absolute low of P/E’s over the last 3 years.  Adding 5 year Return on Equity as a barometer of performance over a difficult period should help too.  Since the market is smacking everything maybe something shakes out.  This should be a chance to pick up cheap earnings multiples and I want to find the best ones.CNX w logo I look for the tall red building in the lower left hand corner of each sector.  That would mean high Average Return on Equity over the last 5 years and a low P/E for today and relative to the last 3 years. For this market period, I am going to stick with the larger names for a buy write candidate.   You should look at each sector independently but what stood out the most were just the two names in Energy, Diamond Offshore (DO) and Consul Energy (CNX). Both have relatively high 5 year returns on equity but the market is marking down their earnings the most.  As of this writing CNX Jun 39 calls for 1.05 with CNX no higher than 35.60 looks interesting for a buy write opportunity. 

Notice a lot of red in Health Care.  No real surprise given health care reform but both Abbott Labs (ABT) and Gilead Sciences (GILD) made new P/E 3 year dead lows as of this writing.  Both are in the upper middle of 5 Year Average Return on Equity for Health Care in the S&P 1500.

The opinions expressed by the author are his alone, and do not reflect the opinions of Aqumin LLC, its shareholders, partners or affiliates.