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 2012. 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 essen-

tially 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

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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 valua-

tions 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 funda-

mentals and valuations. They also must be in the market if they are man-

aging 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 be-

lieve 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, be-

cause interest rates are zero. Since interest rates are zero stocks that

pay dividends are worth much more than traditional valuations would sug-

gest.

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 exam-

ple.

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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 ba-

sically went sideways since 2012 un-

til 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 valua-

tion 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 prob-

lem 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

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sector reaches a high valuation

and then falls into a bear mar-

ket 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 2011. 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 op-

portunity. 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 de-

clining. 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 opportu-

nity. And why I’ll mention another market in a moment.

I believe that this is the easiest way to make big gains in the fi-

nancial 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

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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 cycli-

cally 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:

Sector N0. of stocks CAPE RATIO

Energy 43 13.40

Financial Services 66 21.40

Utilities 30 22.00

Consumer Defensive 44 22.50

Industrials 72 23.90

Basic Materials 25 26.50

Communication Ser-

vices 12 28.00

Consumer Cyclical 77 28.20

Technology 61 30.10

Healthcare 55 30.90

Real Estate 18 63.10

S&P 500 500 27.2

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Here is the historic CAPE ratio for the US stock market. The level

of 15.88 has been it’s historical median. It’s currently at 27.25 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 44.19. 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 1929.

I know most people do not care about valuations. For most people in-

vesting consists in merely buying and believing. Trading and momentum

playing for a few weeks is one thing, but true investing consists in buy-

ing stocks where valuations are cheap.

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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.

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Let’s take a look at the valuations of world mar-

kets. 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 ra-

tio 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.

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 Depres-

sion. People who read the news would have been too scared to invest and

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

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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 2011.

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

$12.00. 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

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 swing-

ing 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

2015.

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 ad-

justed 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 sud-

den 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 0.09. It’s also

trading a 3/4’s of book value. Bank stocks tend to lag after a bear mar-

ket 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 earn-

ings 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.

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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 mo-

ment they are trading in a short-

term range with resistance at 180 on

the HUI mining stock index and sup-

port 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 be-

fore 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 sim-

ple sideways bottoming formation

off the November lows. Gold right

now has resistance at $1,220 an

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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 capitaliza-

tion 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 aver-

age grade of 2.5% copper and an estimated 2.5 g/t gold. Atico's under-

ground 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 2015. 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

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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, be-

cause 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 resis-

tance 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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