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Forecast: The Market Will Bounce Before It Crashes

Posted on June 16, 2011 by admin

In the chart above, we see that the VIX has shot up to its highest levels since March 2011. The VIX is a popular measure of implied volatility for the S&P 500 index options. The price of an option contract factors in implied volatility and a higher option price usually implies higher volatility and a greater probability that the option will expire in the money.

DISCLAIMER: The author of this blog is not licensed under Series 6, Series 63, Series 7, and/or Series 82 and the contents of this blog should NOT be interpreted as providing financial or security advise as determined by the 1934 Securities Act. These blogs are educational only in purpose. The author is licensed as a Washington State Business and Real Estate Broker (Lag #55692) which includes the licensing rights in Washington to facilitate the brokering and sale of businesses, commercial real estate and residential real estate.

The media loves to portray the VIX as a “fear indicator” although it’s really a volatility indicator for both up and down directions. The VIX should be viewed as a indicator that measures the flow of speculation rather than the common belief that it measures the use of options as asset protection insurance.

In the market declines over the last six week, the VIX indicators have been relatively lower than that of a historical sell-off. We’re seeing gradual and steady declines, but a full blown sell-off or market crash will usually have a VIX above 30. I forecast that we’ll see a major bounce around the 200-day moving average especially since the 200-day moving average tends to create psychological momentum for buyers. The Fed announcement on June 22, 2011 as to whether or not it will continue QE2 will have a major impact on whether the market recovers from or falls below the 200-day moving average. If the Fed decides to bail out the economy with QE3, this would increase the probability of a market recovery.

For those that don’t trade in the stock market, the 200-day moving average separates a bull market (above the 200-day moving average) from a bear market (below the 200-day moving average). Expect some bull rallies and a bear/bull fight when we dip below the 200-day moving average. The historical pattern usually shows a rally or bounce on the 200-day moving average prior to the crash below the 200-day moving average. In the chart below, the red line is the 200-day moving average and we can see that the S&P is about to touch it.

Source: JW Jones

June historically has been a bad month in the market because it does not have a lot of announcements and/or news that can drive bullish rallies. As a result, investors remain edgy and lack bullish emotions. We’re now experiencing a stock correction for the majority of stocks that were oversold above their 20-day and 50-day moving averages. The correction in the last few weeks have adjusted the percentage of oversold stocks from over 70% down to 56%.

WHAT IS THE REVERSAL SIGNAL?

The market still remains in a long-term bullish uptrend and we are seeing a short and intermediate correction, but be aware that if we dip below the March 2011 low point (not once but twice) we may see a trend reversal. The catalysts for the trend reversal would be the Greek sovereign debt crisis and a Feds decision on June 22 not to continue quantitative easing.

Falling below the March 2011 low point and the 200-day moving average technically signals whether we’ve reversed into a bear market trend. I believe that we’ll mostly likely see a rally first. If the market falls below below March 2011 low point after this rally, we may see a long-term reversal trend.

Currently, I’ve placed very tight stop losses on my short positions in anticipation of a short-term market rally and I’ve already exited a lot of short positions. When the rally bounces back up to 1290 on the S&P 500, I’ll be looking to reenter many of those short positions with ultra tight stop losses.

This Zempower blog focuses on increasing your Financial IQ. Mr. Taniguchi works with businesses to provide merchant cash advance loans within five to seven days based on credit card revenue receipts. He holds the position of Chief Financial Officer with several companies and also does bookkeeping, corporate valuations, financial consulting, and prepares merger & acquisitions packages for other businesses on the side. If you’d like to get updated blogs, please “Like” facebook.com/zempower.

Posted in Technical Analysis | Tagged 200-day moving average, catalyst for a stock trend reversal, fear indicator vix, implied option volatility, the bounce before the crash 2011, vix indicator, vix volatility indicator | Leave a comment

To Borrow Or Not To Borrow?

Posted on June 15, 2011 by admin

We’ll apply Financial IQ to capital structuring decisions and focus on the question of using debt instruments.

WACC. We use weighted average cost of capital (WACC) as our discount rate in DCF valuations because its the return necessary to satisfy the bondholders and stockholders (relates to the risk/return ratios). An efficient market factors higher levels of risk into the calculation for higher returns. Risk factors include a troubled industry, an inexperienced management team, high levels of competition, economic troubles, inflation, etc. and the greater the time period the greater the uncertainty risks.

Logically, a company should minimize its WACC as much as possible to improve its current valuation. For example, a 30-year loan at 7% will have a lower cost of capital than the expected returns of 17% required for raising equity in the high-growth tech markets. When inflation drives interest rates on corporate loans up to 21%, it would make more sense to get equity financing.

Valuation Considerations. Although financing activities on the statement of cash flow do not affect free cash flow, the capital mix affects the valuation of a company.

Risk Management Applied To Capital Decisions. Debt instruments because of their contractual, residual claim and collateral obligations pose a higher level of risk than equity financing. It’s prudent to use a small to medium use of debt to reduce the cost of capital; however, excessive risk will add a huge element of risk and consequently significantly increase the cost of capital.

Tax Implications of Capital Decisions. The tax-deductible interest on debt plays the role of an interest tax shield compared to shareholder dividends paid after-tax. An unlevered (a company financed entirely by stock) will pay higher taxes that one with debt structures.

Don’t be the fool who believes that all debt is evil or the fool that borrows to pay for the interest on borrowing. Developing your financial IQ means knowing when and when not to use debt instruments.

Posted in Business Valuation, Financial Analysis | Tagged capital decision making, capital structuring, understanding weighted average cost of capital, wacc | Leave a comment

Understanding Beta and CAPM To Improve Your Stock Analysis

Posted on June 14, 2011 by admin

Discussed in previous blogs, the Capital Asset Pricing Model (CAPM) links risk and return through a measurement called beta, which factors out the risk that can be diversified away.

Risk-Free Rate of Return. The risk-free rate of return poses zero risk and usually gets benchmarked to a 10-year U.S. Treasury bond, which was 3.00% on June 13, 2011 (http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield).

Return On The Market. Many analysts use the S&P 500 index as a representation of the overall market. As of the June 13, 2011, the S&P 500 index has an annual return YTD of 2.03%.

Market Risk Premium. The difference between the “market” portfolio and the risk-free rate. Take 2.03% for the “market” portfolio and subtract 3.00% for the risk-free rate. We get -.97%. We can see that 2011 was a very bad year for the stock market since the historical market risk premium averages a positive spread of 5.00%.

Negative Market Risk Premium. Risk premiums must remain positive to encourage investors to take on risks. Logically, why accept a lower investment return with risk and forego a higher investment return with no risk. If a negative market risk premium exists, it signals that a correction maybe just be around the corner. The last time we saw a negative market risk premium was in 2008 and the stock market crashed as investors migrated out of stocks and into bonds. The stock market YTD 2011 again has a negative market risk premium.

Beta. Beta accounts for risk and measures the degree to which a stock fluctuations in the same direction as the overall market condition. A high beta will be highly sensitive to movements in the overall market. To the contrary, “defensive stocks” with a low beta will move a lot less with the overall direction of the market. Negative betas move in the opposite direction of the overall market.

Interpreting Beta. The beta of the overall market is 1.0. Higher betas indicate that the market sees a particularly stock as relatively risky and the expected return goes up accordingly. As the expected return goes up, the company’s valuation using the DCF method goes down.

Application Of CAPM To Cost of Equity. The expected return above equals the cost of equity which is the return required by an investor to compensate them for the risk taken on an investment. Why do you need to know this? If you use the discounted cash flow (DCF) method to value a business, you’ll take the present value of expected future cash flows and discount it by weighted average cost of capital that includes the cost of equity and the cost of debt. A higher cost of equity lowers the valuation of the company.

Posted in Financial Analysis | Tagged buying defensive stocks, calculating beta, capital asset pricing model, capm, cost of equity, expected rate of return, high negative beta, market portfolio, market risk premium, return on the market, risk and return, risk management, risk-free rate of return | Leave a comment

What Caused The Euro Crisis?

Posted on June 13, 2011 by admin

The euro boasts a common central bank but it lacks a common treasury. Member countries share a common currency, but when it comes to sovereign credit they are on their own. This fact was obscured until recently by the willingness of the European Central Bank (ECB) to accept the sovereign debt of all member countries on equal terms at its discount window. This caused interest rate differentials between various countries to shrink which then generated property booms in the weaker economies like Spain, Greece, and Ireland that ultimately crashed.

The euro crisis started when interest rate differentials widened only in 2009 when the newly elected Greek government announced that its predecessor had falsely reported budget deficits that exceeded the limits set by the Maastricht Treaty. Interestingly, the world’s central banks expanded credit to avert a crisis caused by the expansion of credit. The euro crisis temporarily subsided in 2010 with the band-aids of credit expansion, but the wounds will re-open when financial markets start questioning the creditworthiness of sovereign debt in the weaker economies of the EU.

In the 1930’s Great Depression, doubts about sovereign credit forced reductions in budget deficits at a time when the banking system and the economy needed fiscal and monetary stimulus. Keynes taught us that budget deficits are essential for countercyclical policies in times of deflation, yet governments everywhere feel compelled to reduce them under pressure from the financial markets. In 2010, Germany and weaker European countries focus on reducing their own fiscal deficits at a time of high unemployment and a spiral of downward deflation.

Greece will default because they cannot sustain the Maastricht Treaty austerity restrictions during a deep recession. A Greek default will carry sovereign debt doubts over to Italy, Belgium, Spain, and Portugal and credit compression from Greek bank failures will harm Bulgaria and Romania. The collapse of the euro will lead to political tensions in Europe and most likely the collapse of the European Union.

This Zempower blog focuses on increasing your Financial IQ. Mr. Taniguchi works with businesses to provide merchant cash advance loans (up to $2 million) within five to seven days based on credit card revenue receipts. He holds the position of Chief Financial Officer with several companies and also does bookkeeping, corporate valuations, financial consulting, and prepares merger & acquisitions packages for other businesses on the side. If you’d like to get updated blogs, please “Like” facebook.com/zempower.

Posted in Economics | Tagged euro crisis, european central bank, european sovereign debt crisis, greece financial crisis, maastricht treaty, sovereign debt crisis caused the great depression | Leave a comment

How To Perform A Discounted Cash Flow Valuation?

Posted on June 12, 2011 by admin

The Discounted Cash Flow (DCF) method determines the present value of expected future cash flows. After forecasting the future cash flows to be generated by a business, discount them back to the present using a discount rate (which could be the opportunity cost of the funds, the cost of capital, or the hurdle rate).

Terminal Value. The terminal value equals the total forecasted cash flows over a finite number of years and estimates how much the business will sell for at a future date. Terminal value calculations usually assume that a company will reach a moderate steady-state growth rate which can be determined by calculating the present value of a growing perpetuity (an approximation for cash flows that grow forever at a constant rate).

Enterprise Value. The DCF method provides an enterprise value and not necessarily a market capitalization value. An enterprise value equals the total value of all debt and equity capital invested in a company. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

Free Cash Flow (FCF). FCF measures cash flow for valuation purposes and represents the cash available to pay the bondholders and stockholders. FCF can be negative especially for start-up companies with immature operating incomes. In mature companies, negative FCF can be caused by economic downturns, mergers & acquisitions, or sudden changes in net working capital. In calculating FCF, we can’t just simply add cash flow from operating activities and cash flow from investing activities. Cash flow from operating activities will include interest expenses (per the GAAP requirement) and also non-operating income in net income. Cash flow from investing activities includes the purchase and sale of short-term investments which is not an operating income.

FCF = EBIT(1-Taxes) + noncash expenses (such as depreciation and amortization) – capital spending – investment in working capital.

Growth Rate Assumptions. The revenue growth YOY affect the DCF valuations and can only be guessed. Mature companies usually have long-term growth rates of 3% and moderate growth companies have 5-year high-growth periods and slightly higher long-term growth rates around 5%. A high-growth company in an emerging technology company may have 10 years of high-growth and higher long-term growth rates at 7%.

Discount Rate. The higher the discount rate used, the lower the enterprise value of the company. The discount rate accounts for risk and ultra high risk companies should be adjusted with a high discount rate. The discount rate should also factor in the weighted average cost of capital (WACC) which changes in proportion of the ratio of equity, debt and preferred stock in the capital mix.

Sensitivity Analysis. We can see that the valuation varies considerably depending on the growth rate and discount rate/cost of capital assumptions. A sensitivity analysis allows us to examine various combinations of growth rates and discount rate/cost of capital assumptions.

A company should be worth the present value of its expected future cash flows. However, we can see that the DCF value wildly fluctuates based on the assumptions that we plug in.

Posted in Business Valuation | 1 Comment

How To Measure Financial Performance?

Posted on June 10, 2011 by admin

Financial ratios provide insights regarding the financial performance of a company, but they do not explain the underlying root causes of this performance or non-performance. For the purpose of comparing the financial performances between companies, an accountant will create a common-size income statement expressing all items as a percentage of sales, and common-size balance sheet shows all items as a percentage of total assets. Lets look at different ratios useful in measuring financial performance.

Activity Ratios. Measures the efficiency of a company’s operations. Usually turnover is a positive (except for days payable outstanding) and time elapsed is a negative.

Receivables Turnover = Revenue/Accounts Receivable
Inventory Turnover = Cost of Goods Sold/Inventory
Payables Turnover = 365 Days/Receivables Turnover
Days Sales Outstanding (DSO) = 365 Days/Receivables Turnover
Days Of Inventory On Hand = 365 Days/Inventory Turnover
Days Payable Outstanding (DPO) = 365 Days/ Payables Turnover
Total Asset Turnover = Revenue/Total Assets
Fixed Asset Turnover = Revenue/Fixed Assets

Liquidity Ratios. Measures the company’s capacity to meet short-term obligations. The bigger these liquidity ratios the better.

Cash Conversion Cycle = Days of Inventory On Hand + Days of Sales Outstanding – Days In Payables. The shorter the cash conversion cycle the better.
Cash Ratio = (Cash + Short-Term Marketable Securities)/Current Liabilities
Quick Ratio = (Cash + Short-Term Marketable Securities + Receivables)/Current Liabilities
Current Ratio = Crurent Assets/Current Liabilities

Solvency Ratios. Measures the company’s capacity to meet long-term obligations. Coverage is good and debt is bad. When the debt-to-assets ratio goes up and the interest coverage ratio declines, this red flags higher insolvency and default risk.

Interest Coverage = EBIT (Operating Income)/Interest Expense
Debt-To-Equity Ratio = Total Debt/Total Shareholders Equity
Debt-To-Assets Ratio = Total Debt/Total Assets
Debt-To-Capital Ratio = Total Debt/(Total Debt + Total Shareholder’s Equity)
Equity Multiplier = Total Assets/Total Shareholder’s Equity

Profitability Ratios. Measures the company’s ability to earn a profit on sales after deducting expenses incurred from using its assets. The bigger the profitability ratios the better.

Gross Profit Margin = Gross Profit/Revenue
Operating Profit Margin = Operating Income/Revenue
Pretax Profit Margin = EBT (Earnings Before Tax)/Revenue
Net Profit Margin = Net Income/Revenue
Operating Return On Assets = Operating Income/Total Assets
Return On Assets = Net Income/Total Assets
Return On Invested Capital = Net Income/Total Assets
Return On Equity = Net Income/Shareholder’s Equity

Understanding these ratios unlocks some amazing insights into the health and performance of a business.

Posted in Financial Analysis | Tagged common-size balance sheet, common-size income statement, financial ratios, how to measure financial performance | Leave a comment

Financial IQ Applied To Business Valuations

Posted on June 8, 2011 by admin

Some companies may hide some things in their financials that should be accounted for in a business valuation. Let’s look at some examples.

Historical Value vs. Fair Market Value. The Historical Value utilizes the acquisition value of an asset or liability including acquisition, preparation, or installation cost. The Fair Market Value estimates the asset value that a buyer would pay or the amount for which a liability will be fulfilled. For current assets and current liabilities the numbers on the balance sheet tend to be decent approximations. Long-term assets such as plants, property and equipment tend to be undervalued on the balance sheet because accounting rules usually value them at their acquisition price. Land tends to go up in value and equipment after being fully depreciated holds significant economic value when properly maintained.

Off-Balance-Sheet Items. One of the most common (particularly in the retail industry) off-balance-sheet items is an operating lease. For example, in 2009 McDonald’s held $10 billion in operating lease obligations that did not show up on the balance sheet compared to assets totaling $30 billion. The off-balance-sheet operating leases for McDonalds obviously had a significant impact on the value of the company.

Intangible Assets. Most accountants will not provide monetized value for internally generated intangible assets such as brand recognition, patents, trademarks, trade secrets, and customer lists. Intangible assets are usually only added after the acquisition of another business.

Finite vs. Infinite Useful Life Of Intangible Assets. If an intangible asset has a finite lifespan, you calculate the period of time for its identifiable useful and amortize it using the straight-line method (ignoring any residual value). For intangible assets with an infinite lifespan, you don’t use amortization. Instead, an accountant will test the assets annually for impairment, which means that if their value becomes impaired then the accountant reduces the carrying value on the balance sheet. These write-offs on the carrying value affect the business valuation and need to be carefully analyzed.

EBITDA Multiples Great For Larger Small-To-Medium Size Businesses. Because most S-corporations and LLCs are pass-through tax entities, it makes sense to add back tax in the valuation process. Depreciation and amortization are accounting values and do not effect the businesses cash flow. EBITDA Multiples are common for technology, manufacturing, and professional services companies.

Straight-Line vs. Accelerated Depreciation. The depreciation method used can greatly influence the valuation method, and this is another reason why the EBITDA Multiple Valuation method is popular especially for small-to-midsize companies.

Interest Expense In The Cash Flow Statement Operating Activities. Under the rules of GAAP, this category includes interest expense even though it comes from financing activities.

Burn Rate. The rate at which a company is “burning” cash and equals the values for operating and investing cash flow. Compare the burn rate to the amount of cash the company has on the balance sheet to determine how long a company can survive.

Posted in Financial Analysis | Tagged balance sheet carrying value, balance sheet impairment, balance sheet write-offs, ebitda multiple valuation, finite vs. infinite useful life and intangible assets, historical value vs. market value, how to read a balance sheet, how to value a business, off-balance-sheet items, operating leases, valuing an llc, valuing an s-corp, when to count intangible assets | Leave a comment

How To Value A Business?

Posted on June 7, 2011 by admin

Whether you’re looking to procure capital financing for a business, qualify for a loan, sell or buy a business, or set-up an employee stock option program, a business person needs to know how to value a business. Let’s look at some of the methods that the financial pros use to do this.

Method 1: Discount Cash Flow Valuation Method. The value of a business is the present value of its expected future cash flows. We makes this determination by forecasting the cash flows that we expect in the future and “discount” them back to the present to account for time and risk.

In the above equation, I equals the cash flow we expect to receive one, two, ….. n years from today and r is the discount rate (similar to an interest rate) used to determine the present value of future cash flows. The Net Present Value can be best thought of as the “fair value” of a business. Sellers should hope to get paid more than the NPV, and buyers want to pay less than this value.

Method 2: Price Multiplier Valuation Method. This valuation method compares the relative value of multiple businesses in similar market sectors and industries. The comparisons can be based on earnings, EBITDA (earnings before interest, taxes, depreciation and amortization), or the price-to-earning ratios.

Method 3: Liquidation Valuation Method. This valuation method takes the total assets and subtracts from it the total liabilities. In actuality, this method would only apply during the distressed sale of a business going out of business. When using the price multiplier and discount cash flow valuation, we assume that the company will remain a going concern (expected to continue operations). This “fire sale” valuation method shows the “worst case scenario” value of a business and is often the value used by banks in determining loan eligibility.

Posted in Financial Analysis | Leave a comment

Will The Stock Market Crash In June 2011?

Posted on June 2, 2011 by admin

On March 3, 2011, I forecasted on this Zempower blog that we could double-dip into a global depression. On February 21, 2011, this blog forecasted that the S&P 500 could drop to 5,000 sometime in 2011. No one can ever know the exact timing of a stock market crash. However, I believe the possibility exists that the crash may start this month in June 2011. Of course, one can keep “crying wolf” and the funny thing is that if you keep forecasting that the stock market will crash one mathematically is bound to eventually be right. In other words, take these forecasts with a grain of salt. For example, we have not seen the type of irrational high-volume buying momentums that usually proceed a great market crash.

THE RELATIONSHIP BETWEEN BEAR MARKET BOTTOMS, P/E RATIOS AND DIVIDEND YIELDS.

Historically speaking, the bottom or lowest point of a bearish market has always occurred when when the dividend yield exceeds the P/E ratio. If you think about it, this makes sense. A stock value equals its dividend return plus its growth rate. Whenever the dividend yield exceeds the P/E ratio, we’ll see “value” investors come out and buy these underpriced stocks. During the 1932 bear market bottom, the P/E ratio at 10 fell below the dividend yield of 10.50%. During 1942 bear market bottom, the P/E ratio at 7.3 fell below the dividend yield of 8.71%. During the 1974 bear market bottom, the P/E ratio at 7.24 fell below the dividend yield of 5.9%. During the 1982 bear market bottom, the P/E ratio at 6.9 fell below the dividend yield of 6.2%.

In the chart above, we see that the S&P 500 stock market reached a low bearish point on March 9, 2009. At this specific low point, the P/E ratio of 26 greatly exceeded the dividend yield of 3.2% and this signals that we have not reached the bottom of the bearish cycle. So I ask the rhetorical question, “Can the S&P 500 drop to below 5,000?” The big crash may not happen in June 2011, but I believe the worst is still to come sometime in 2011 or 2012.

Regardless of whether we actually crash to 5,000 or not, my trading position has been extremely bearish. Since the middle of May, I have only been trading Bear Put Spreads on the Energy and Material sectors. While I took some initial loses and got automatically knocked out of other trades through “stop losses,” it seems like I’m well positioned now if a major crash occurred in these sectors.

The Energy sector shows some conflicting signs. I wrote a blog post titled “Will Gas Prices Keep Rising?” on March 7, 2011. In this blog post, I outlined a historical negative correlation between the value of the US dollar and oil prices. Over the long run, I believe that the dollar will crash as a result of a current account deficit correction. In the short term, four factors have been holding up the US dollar: 1) a crash in commodity prices particularly the uncertainty in the silver markets 2) uncertainty in the Euro related to the sovereign debt crisises in Greece, Spain, Ireland and Portugal 3) slowdowns in the Chinese economy and uncertainty in Japan after the massive earthquake and 4) the likely end of QE2 in June 2011. Some oil experts forecast gas prices to drop to $3.62 a gallon in the near future. Again, in the long term I expect gas prices to rise as the US dollar collapses in value, but in the short term I forecast that gas prices will fall.

Posted in Stock Market, Technical Analysis | 1 Comment

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