Understanding the Stock Market, Learning About the PE Ratio

If you’ve ever read anything about the stock market I am sure you would have heard the term P/E ratio. This term stands for price earnings ratio and when it comes to valuing stocks it is one of the oldest and most frequently used metrics.

Although it is a simple indicator to calculate it can actually be quite difficult to interpret. In some situations it can be informative and in others it is meaningless, and because of this investors often misuse the P/E ratio.

The P/E ratio is the ratio of a company’s share price to its per-share earnings. To calculate it you just divide the market value per share by the earnings per share (EPS). The P/E ratio will usually be calculated using EPS from the last four quarters (known as trailing P/E). it can also be calculated using estimated earnings over the next four quarters (known as leading or projected P/E).

After you have calculated the P/E ratio there are a number of different ways in which you can use it. Theoretically P/E tells us how much investors are willing to pay per dollar of earnings. A P/E ratio of 20 tells us that investors are willing to pay $20 for every $1 of earnings. P/E can also be seen as a reflection of the market’s optimism concerning a company’s growth prospects.

If the company has a higher P/E that the market or industry average it means that the market is expecting big things over the next few months or years.

The P/E ratio is a much better indicator of the value of a stock than market price alone. All things being equal a $10 stock with a P/E of 75 is much more expensive than a $100 dollar stock with a P/E of 20. Just remember that there are limits to this form of analysis you can’t just compare the P/Es of two different companies.

A common mistake that beginner investors make is the short selling of stocks because they have a high P/E ratio. Valuing a stock based solely on a simple indicator like the P/E is a very bad idea and can get you into serious trouble.

So what have we learnt about the P/E ratio. Although it doesn’t tell us much it can be useful to compare the P/E of one company to another in the same industry, to the market in general or to the companies own historical P/E ratios. Analyzing securities requires a lot more than just understanding a few ratios, while P/E is one part of the puzzle it is not the be all and end all.

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The Carry Trade - What is it? How to Play it?

There’s been a lot of press lately about the Carry Trade, and like all catchy trends in the investing world, by the time it’s a routine fixture on CNBC and blogs, the smart money’s been made and retail investors are left holding the bag when the bubble bursts (anyone recall housing 2007, oil 2008?). Conversely, the trend is your friend and given the continued decline of the US dollar of late, we may very well see this trend continue for months. In a flat or downward stock market following a 60% move from the bottom, the carry trade may be a nice place to earn a double digit gain in the meantime.

What is the Carry Trade Exactly?

Essentially, because the US has a near 0% interest rate and other economies have higher interest rates or are even raising them due to the relative strength and confidence in their economies (like Australia), currency ETFs such as FXA (Aussie Dollar) are on fire. This year, you would have even done better in FXA than the S&P500, even given the recent rally.

YTD Return FXA +28% vs. S&P500 +15%

As outlined in this article on Currency ETFs, there are some currencies that are making great gains against the US Dollar and investors could have captured some nice low-correlation gains alongside stock gains in the past few months and this may continue.

With all the talk of the US Dollar being displaces as the reserve currency of choice, we’ve seen gold rally to all-time highs, which is very much a function of the weakening dollar (see why silver-platinum ETFs are even better investments than gold in a weak dollar environment) as opposed to a supply shortage or industrial demand.

Meanwhile silver and platinum benefit from actual real-world industrial utilization and are more leveraged to a weakening dollar even than gold. However, aside from a commodities trade or trying to pit Australia alone vs. the US, another ETF that goes long the highest yielding currencies and short the lowest yielding currencies is DBV - PowerShares DB G10 Currency Harvest. This one is considered a broader play on the carry trade rather than betting on the relative strength of individual currencies. Carry Trade Bubble Risk

To be clear, playing the carry trade this far into the dance is not without risk. Prominent B-School professor and oft-doomsayer Roubini has been warning of the imminent collapse of the mother of all carry trades. The video’s a bit long, so I’ll summarize. He warns that when the carry trade reverses (the bubble bursts) and investors have to cover their short dollar positions, panic will ensue and investors will rush for the exits. In doing so, the dollar will rally to the tune of 25% or more and overseas currencies will crash precipitously. Those that are long foreign currencies and short the US dollar will get crushed. Indirectly, all risky assets will suffer including stocks and bonds like we saw in 2008 into 2009.

This would be akin to what we saw during the global collapse and complete capitulation of the investment world at large in March 2009 where even the weak dollar-gold correlation broke down for the first time in years - and then promptly recovered as we’re seeing now. Therefore, if you’re a contrarian and want to wait it out for this bubble to burst, you’d want to stay out of commodities, stay out of the foreign currency ETFs and just go long the dollar or Treasuries.

Darwin’s Finance
http://www.darwinsfinance.com
Evolutionary Finance for the Masses

Article Source: http://EzineArticles.com/?expert=Dan_Pritch