Daily Gains Letter

What to Really Look for in This Overvalued Market

By for Daily Gains Letter |

Overvalued MarketWhen it comes to investing, I think it’s important to have a balanced investment portfolio made up of value and growth stocks. I also think it’s important to be balanced in the way you look at or research stocks through both fundamental analysis and technical analysis. Being too extreme or having too much allegiance to one investing methodology means excluding a rich pool of information.

I have an acquaintance who’s an investor. He swears by day-trading, even though he’s lousy at it. Here, I’d like to employ Dr. Phil’s mind-numbing, near-sighted phrase, “How’s that workin’ for ya?” but to be fair, I don’t really know too many successful day-traders anymore.

Anyway, my friend, whom I call “the investing dandy,” is a pure technical analysis trader, meaning he doesn’t even care what stock he’s trading and most times, he doesn’t even know what the company does.

Technical analysis attempts to forecast future price movements based on past price and volume movements. The idea is to find patterns within the past movements, and use those chart patterns and past price performance to predict what will happen to the stock in the future.

Fundamental analysis, on the other hand, looks at a company’s financial statement in an effort to predict a trend. Unlike technical analysis, which considers the past direction of a chart to predict a stock’s future movements, fundamental analysis focuses on the forward-looking picture.

My friend contends that because the markets have been performing so well over the last few years in spite of lukewarm earnings, there’s no reason to consider a fundamental analysis.

Therein lies his folly. While he’s right that the stock markets moved irrationally higher in 2013 on the back of weak earnings, he’s wrong that the markets will continue to do so. In fact, the markets are so overvalued right now that investors will be looking for significantly higher earnings growth to justify any upward price movement.

And you can only understand a company’s potential for growth if you put it under the microscope of fundamental analysis. So, after a year when technical analysis helped stocks with weak earnings generate solid double-digit gains, I think 2014 will be an equalizer, where fundamental analysis will come back into favor.

After the markets crashed in 2008 and lending dried up, some of the only firms that performed well in the early days were those that had strong cash positions.

While those banks that survived the Great Recession are only more than happy to lend out cash now, creditors still see a strong cash position as an indicator of a company’s financial safety. Aside from being a barometer of economic health, it can also provide a company with enough liquidity to grow the company through acquisitions.

Lorillard, Inc. (NYSE/LO) is the third-largest cigarette maker in the U.S. and is the name behind Old Gold, True, and the number-two-selling brand, Newport and Kent. Technical analysis will show you the company’s share price is up roughly 32% year-over-year. A fundamental analysis shows Lorillard has a forward price-to-earnings (P/E) ratio of 14.0, while 62% ($1.64 billion) of its assets are in cash.

GAIN Capital Holdings, Inc. (NYSE/GCAP) provides trading services and solutions to retail and institutional customers. A technical analysis shows the company’s share price is up a solid 117% year-over-year. A fundamental analysis reveals the company has a forward P/E of 9.68 and 76% of its total assets are in cash.

Picking stocks for your retirement portfolio is about balancing fundamental and technical analysis. While it takes more than cash to make a company run, it’s certainly not a bad idea to add inexpensive stocks with a strong cash position to your portfolio.

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