IN THIS CHAPTER
Working your way down the ladder by assessing the market and the industry
Employing screens to discover swing trading candidates
Figuring out which method works for you
You can identify fundamentals-based trades (and technical-based trades for that matter) in two ways: by beginning with the security’s market and drilling down into the promising industries or by identifying candidates with promising characteristics on a grassroots level. One approach is top down, whereas the other is bottom up. Both ways have merit.
This chapter outlines how to identify promising candidates to buy using a fundamentally driven top-down or bottom-up approach — and how to determine which approach is right for you.
The top-down approach identifies promising swing trading candidates by starting with market analysis (looking at stock markets, commodity markets, currency markets, and the like). Then it drills down into specific industries before finally examining individual securities. This approach implicitly argues for greater weight on markets and industries over the merits of an individual company because these big-picture items are more important in determining a security’s return than company-level factors.
A top-down trader cares less whether she swing trades XYZ Oil Company or ABC Oil Company (based on the individual characteristics of each company) and more about whether he or she is trading an energy stock or a drug stock in general. (I say “in general” because some fundamentally driven swing traders look for specific catalysts to decide which stocks to swing trade — such as a better than expected earnings report, the launch of a new product, or the firing or hiring of a CEO. For these swing traders, the company is of utmost importance — more than the market or industry).
The following sections break down the basics of the top-down approach and explain details of how to dig into the market and industry analysis to benefit from the top-down approach.
The top-down approach allows you to understand the condition of the overall market, which is valuable because the majority of securities follow trends in the overall market. For example, if the stock market is dreadful and hits new lows every few weeks, you probably won’t find many great candidates to buy. On the other hand, if the market is roaring to new highs, choosing winning stocks is much easier because the wind is at your back.
Using this approach, you begin by determining if the market is overvalued or undervalued. Now, I wish I could tell you that the market is so efficient that when it’s overvalued, it quickly snaps back and becomes properly valued. Or that when it’s undervalued, it promptly snaps back and becomes properly valued. Sadly, this isn’t the case. Markets can become and remain over- or undervalued for significant periods of time — even years. For that reason, you evaluate whether the market is overvalued or undervalued on a fundamental basis, but put greater weight on the technical chart to swing trade.
After evaluating the market, you question whether the industry is likely to outperform or underperform the market. Finally, you look at the individual security to see whether its statistics are impressive enough to warrant investment.
Determine the state of the overall market — is it cheap or not and what direction is the trend?
This step allows you to determine whether the overall market is cheap or expensive. As a swing trader, you don’t have time to call analysts, survey government data, and build an economic model that perfectly captures all information that may influence an overall market. Even if you did have the time for all that, I’ve never seen proof that such complexities improve forecasting abilities (my apologies to my statistics and economics professors). You look at some basic measures of market valuation, but at the end of day you must put greater weight on the technical picture to tell us whether to trade or not.
Assess the prospects of different industries in the market.
This step helps you focus on promising industries so that the wind is at your back when you buy securities within that industry. If the market just bottomed, for example, you will want to focus on those industries poised to outperform the market. Being right on the overall market and wrong on the industry may leave you with losses.
You can’t identify good swing trading candidates with the top-down approach without first evaluating the overall market. Fortunately you can choose from three measures to determine whether the overall market is cheap, fairly priced, or expensive.
The long-term P/E ratio method of determining whether a market is over- or undervalued is the crudest and simplest method you can use. It simply compares the market’s current P/E to its long-term average. The real question is: Do you look at the P/E based on the last 12 months of earnings, or do you look at it based on the expected earnings in the coming 12 months?
Reviewing the expected earnings over the next 12 months makes more sense than relying on historical earnings. After all, companies are valued based on their future, not their past. Historical earnings are especially unhelpful at points of inflection, where a major turn happens in the economy. The recent past looks very little like the coming future.
Fortunately, Standard & Poor’s (S&P) publishes the P/E of the S&P 500 Index based on both historical and future earnings. The S&P website (
https://mena.spindices.com/indices/equity/sp-500) provides spreadsheets that show the P/E for the S&P 500 Index (large companies), the S&P 400 Index (mid cap companies), the S&P 600 Index (small cap companies), and the S&P 1500 Index (the broad market). To download these spreadsheets, go to the S&P website and click on the drop-down menu of Additional Info and select Index Earnings. The Excel sheet that automatically downloads has a wealth of info on the P/E ratio based on trailing 12-month earnings as well as estimated earnings for the coming 12 months.
From 1954 through 2018, the average P/E of the S&P 500 Index — which represents a large part of the market — has been 16.6 (see Figure 8-1). When the market trades significantly above this level (say 20 times earnings), that can indicate the market is overvalued. When the market trades well below this level, that may signal that the market is undervalued.
The long-term P/E ratio method has the following downsides when it comes to valuing a market:
It isn’t useful as a short-term timing vehicle. The P/E model isn’t a short-term trading model and hence may hurt swing traders that depend on short-term price movements. It tells you the direction the wind is blowing, but sometimes the market ignores reality and marches the wrong way. Eventually, the market gets it right. But in the near term, this gap in accuracy may cost you a lot of money.
Solve this lag by incorporating technical analysis with the P/E model. If the P/E model indicates that the market is undervalued but the trend is down according to the charts, don’t fight the tape. Instead, stay in cash or trade a different asset class. However, be alert for signals of a trend change. The near-term weakness may not be sustainable, and the market may be due for a rebound. Similarly, if the P/E model indicates the market is overvalued but the trend is definitively up, don’t argue with the market. Buy stocks, but keep tight stop-loss orders to protect yourself when the fundamentals prove out and the market takes a swoon. Be on the lookout for divergences in technical indicators.
The Fed Model compares the yield of the market to the yield of the ten-year U.S. Treasury Note. So essentially it compares the return you may expect to earn in stocks with a major competing asset class so that you aren’t examining stocks in a vacuum. As a result, you have a reference point from which to base your estimation of the market’s current value. For example, when the stock market is offering a higher yield than fixed income instruments, this model assumes that investors will migrate to stocks. When fixed income instruments are offering a higher yield than stocks, the model presumes that investors will flock there.
Determine the market’s P/E.
Most websites report the S&P 500 P/E ratio. You can also download the data from the S&P website provided earlier in this chapter.
Calculate the inverse of the market’s P/E to determine the market’s earnings yield.
The math is easy here. If the P/E is 12, calculate the inverse by taking 1 and dividing it by 12 (that is, 8.33 percent). If the P/E is 20, the inverse is 5 percent.
Find the yield on the ten-year Treasury Note.
You can locate this number online (try
www.bloomberg.com/markets/rates/) or you can look it up in The Wall Street Journal.
Suppose the P/E of the S&P 500 Index today is 15. That means the earnings yield is 1 divided by 15, or 6.67 percent. For purposes of this example, say the yield on the ten-year Treasury Note is 4.50 percent. Based on the Fed Model, stocks are undervalued because the yield on the S&P 500 Index is higher than the yield on the Treasury Note.
One criticism of the Fed Model is that U.S. Treasury government bonds provide lower yields than other bonds. (The lower the yield, the more attractive stocks look when compared to bonds.) U.S. Treasury government bonds are considered “risk free” because the U.S. government has the power to print dollars. Therefore, the U.S. government is unlikely to default on bonds it issues. Some investors feel comparing the yield on companies in the S&P 500 Index, which can default, to the yield of a government security is unfair.
The adjusted Fed Model compares the earnings yield on stocks to corporate fixed income securities. But you can’t compare yields to just any bonds; different types of bonds carry different levels of default. The higher the potential default, the higher the yield. It’s unfair to compare buying shares of Coca-Cola to buying a security issued by a troubled home lender likely to default on its obligations.
Rating agencies, primarily Standard & Poor’s (S&P) and Moody’s, measure the likelihood of a company defaulting on its obligations and assign rankings to different fixed income security. S&P’s scale ranges from AAA (representing the highest-quality companies) to D (representing ready-to-default securities). Moody’s scale ranges from Aaa (highest) to C (lowest).
Figure 8-2 highlights a table taken from Yahoo! Finance’s that breaks down the different rankings assigned by S&P and Moody’s. Investment-grade securities, which many institutional investors are restricted to investing in, have ratings between AAA and BBB on the S&P scale and Aaa and Baa on the Moody’s scale. These fixed income securities tend to be higher-quality and have a low risk of default. Fixed income securities that are below investment grade have a higher frequency of default (often higher than 1 percent).
So where can you get this information? Fortunately, it’s provided free of charge at websites like the Wall Street Journal’s homepage (under “Market Data Center”). Figure 8-3 shows a snapshot from the Yahoo! Finance site that provides the yield on fixed income securities with different ratings and maturities (the term of the security). Notice that the yield on ten-year AA-rated Corporate Bonds is 5.60 percent.
Now that you know the yield on ten-year AA Corporate Bonds, you can compare that to the yield on stocks. Suppose the P/E of the S&P 500 Index is 19 today. That means the earnings yield is 1 divided by 19, or 5.26 percent. Using the information provided in Figure 8-3, you know that the yield on ten-year AA Corporate Bonds is 5.60 percent. Based on the adjusted Fed Model, stocks are overvalued relative to bonds because the yield on ten-year AA Corporate Bonds is higher than the earnings yield on the S&P 500 Index. As a swing trader, you should be alert for weakness in stocks.
Industries largely determine the profits of companies. Naturally, profits differ between Delta and United Airlines, but even larger differences exist between a grocery store chain and a PC manufacturer. Therefore, take special care in determining the attractiveness of an industry using fundamental characteristics.
You can identify which industries to focus on by looking at
Industry fundamentals: Just as you determine whether a stock is cheap or expensive based on items like P/E, return on equity, and expected earnings growth rates, so too can you value industries based on these same factors. The two best places to get this information are Yahoo! Finance (free) and HGS Investor software (paid).
Professor Aswath Damodaran of New York University maintains a wealth of data on industry groups on his website for free:
The following data can be reviewed for all industry groups in the United States from Professor Damodaran’s website:
Figure 8-4 is a snapshot taken from data downloaded from Damodaran’s website. Notice that the biotech industry has the lowest PEG ratio. The PEG ratio in Damodaran’s website uses the “aggregate market cap/trailing net income” measure, which excludes loss-making companies. Also notice that the P/E ratio for the biotech industry is 54 when looking at all companies and 17 when excluding loss-making companies. Biotech companies are often loss making; hence, there is a wide spread between the two P/E ratio measures. I prefer to look for industries where the P/E ratio isn’t materially different when excluding lossmaking companies or when including them.
From this list, I want to dig deeper into the auto and truck industries (which have high expected earnings growth rates) and software Internet (keep in mind that anything in the top 20 percent should be fair game). These industries show high expected earnings growth rates with P/E ratios that are low and not significantly different when excluding loss-making companies.
Just because an industry has attractive fundamentals doesn’t mean you can ignore the price action of that industry group. Instead, the price action (the chart and technical indicators) should be in alignment of the attractiveness of the industry.
After identifying the strong industry group you want to swing trade, drill down into the companies that make up that industry to find the most over- or undervalued candidate based on the Six Step Dance in Chapter 9.
The bottom-up approach is starkly different from the top-down approach, which I describe earlier in this chapter. Instead of beginning with the overall stock market and moving to the industry group, the bottom-up approach places less emphasis on overall economic cycles by beginning at the company level and working its way up. If you favor fundamental analysis over technical analysis or are trying to find promising candidates in a weak market, you may favor the bottom-up approach over the top-down one. If you excel at swing trading securities based on events — such as a change in CEO, an earnings report, or an acquisition — you should also favor the bottom-up approach.
The bottom-up approach usually begins with some type of screen, which you use to identify promising candidates. Some screens are very liberal — they generate dozens of possible candidates, diluting the amount of time you can spend on any one. Other screens are very conservative — the criteria used are so stringent that you may have only five or six possible candidates to evaluate. Think of using a fundamentals-based screen as sifting for gold. A lot of garbage surrounds those valuable nuggets, and your job is to find them amid all the trash. In the following sections, I show you how to do just that.
Fundamental screens can consider everything from earnings growth rates to average daily volume to changes in consensus earnings estimates. Sometimes this variety leads to information overflow, which may be discouraging if you’re using a fundamental screen for the first time. Fortunately, because you create your own screen using the criteria you want to focus on, you don’t need to bother with the premade, too-much-information batches vendors peddle to the public.
In addition to covering the general screening criteria to use, I delve into two screens: a growth-oriented screen and a value-oriented screen. I show you which criteria you really need to examine for each type of screen in order to sift effectively. Note: These screens are for illustrative purposes only to guide your development of your own screens. I recommend you specialize to enhance your trading. In other words, perhaps you’re a swing trader focused on high growth companies that have had a recent pullback on light volume. Or perhaps you focus on companies that just announced earnings exceeded estimates. You’ll be the best swing trader when you specialize in swing trading specific fundamental patterns. You don’t need to be a jack-of-all-trades (or jill-of-all-trades) to be a successful swing trader.
Figure 8-5 highlights the one-year and five-year returns for growth and value stocks in the large (Russell 1000), mid (Russell Mid Cap), and small (Russell 2000) cap arenas.
Notice the striking differences in returns. Over the five-year period ending December 21, 2018, the Russell 1000 Value Index (large cap value) generated an annualized return of 5.71 percent versus the Russell 1000 Growth Index’s (large cap growth) 9.75 percent return. If you convert the annualized return (which is like an average return over the period) into a total return (how much the index rose in total over the five-year period), the figures look even more astonishing: The large cap value index rose 32.0 percent during the five years while the large cap growth index rose 59.2 percent.
You can see why knowing which horse is in the lead matters. When growth is in favor, as it clearly was during these time periods, swing trading growth stocks is like flying a plane with strong tailwinds. Swing trading value stocks can be profitable as well, but the headwinds lower your overall return.
So growth is the place to be, right? Actually no. It depends on the time period used. In the first edition of this book, the five-year performance of value was significantly higher than growth over a five-year period ending in December 2006 (value delivered 67.5 percent versus growth’s return or 14.2 percent). At different times, value and growth outperform one another.
Before you start working with screens, you should note that value and growth screens tend to have similar characteristics. For example, both screens should exclude low-priced securities and securities that trade infrequently. When looking for candidates, they should both include a field for high return on equity.
A major difference between value and growth screens is that growth screens tend to focus on earnings growth rate fields, whereas value screens focus on valuation metrics like P/E ratios. Additionally, some fields differ between the two. For example, low-priced stocks are often identified using the price to sales ratio. Growth stocks are rarely found using that measure.
The important criteria to include in a growth screen include:
Growth stocks typically reside in the technology, healthcare, and consumer discretionary sectors, but they can reside in other parts of the market as well. Following are the factors that characterize growth companies:
Growth stocks exhibit high earnings growth rates. Therefore, the following growth screen, which can be implemented with most popular screening programs, focuses on earnings growth recently and historically. Although the method of inputting these screening functions is largely dependent on the screening program you use, I recommend you always input these numbers:
Value stocks are characterized by low valuations, first and foremost. Value screens must hone in on the valuation metric via popular statistics like P/E, PEG ratio, or the price to sales ratio (P/S). You don’t emphasize earnings growth rates or sales growth in value stocks. Although finding a company with strong earnings growth rates makes a value stock that much more attractive, don’t exclude a company for consideration just because earnings may not be growing rapidly and, in fact, may be declining.
A value screen is most helpful when value stocks are outperforming the market. Value stocks are characterized by their industries and their valuations relative to the overall market.
Here’s a value screen you may use to focus on promising candidates by using the P/S valuation metric (remember, this is just one example, and one I recommend — you should experiment and develop your own screen for selecting securities):
The first two fields restrict you to an investment universe that trades often and above $5 per share. The next ranking restricts you to so-called cheap securities, as measured by P/S. Value stocks often pay dividends, so I like to see some dividend payout. But beware of companies that pay dividends of 10 percent or more. These companies are often distressed and about to cut their dividend payments. Finally, the relative strength ranking helps ensure you concern yourself only with securities performing in the top 20 percent of the market. These securities tend to outperform the market in the near term.
After completing your screen, you need to have some kind of ranking system so you can focus on the most promising candidates first and work your way down. You can rank securities by their P/E ratios, for example, from lowest to highest. Or you can rank securities by their return on equity or price to free cash flow ratios. Ranking helps you push the cream to the top.
When identifying a promising swing trading candidate using a fundamental screen, the right security should jump out at you. You shouldn’t have to do a lot of equivocating or questioning. Here’s how to analyze your results:
Which approach should you use? As much as you may hate to hear it, this question doesn’t have a right answer. The approach you choose is solely dependent on your style of trading. Do you prefer to identify the ripe industries that are poised to take off? If so, use the top-down approach. Do you enjoy developing screens and then examining the filtered results for promising candidates? In that case, use the bottom-up approach.
Fundamentals-based investors are usually bottom-up oriented. Swing traders and technical traders are often top-down oriented. However, a fundamentals-based trader can be top-down, and a technical swing trader can be bottom-up. Remember: There’s no right or wrong way. The promising candidates are the ones that you find regardless of whether you begin with a top-down or bottom-up approach.