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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST Monday, December 4, 2006: It's time to take a little more money off the table. Cash is good and pays well -- over 5.20% at many banks -- more than many hedge fund managers (especially two of mine) earned in 2006. And there are clouds on the horizon:

+ Falling dollar.
+ Slowing growth.
+ Washington gridlock -- the administration versus Congress, etc.
+ Accelerating Iraqi problems.

From weekend reading -- part 1:

When Wall St. Looks Like Pamplona, Sound an Alarm
by Mark Hulbert, editor of the Hulbert Financial Digest

INVESTMENT newsletter editors are about as bullish as they have been in nearly five years — and that doesn’t bode well for the stock market.

When investors are wildly optimistic, head for the hills; when they are truly pessimistic, buy stocks. That, at least, is the counsel of contrarian analysis, which derives its name from the idea that the market, in the near term, rarely does what the majority expects it to do.

When pessimism and despair reach extreme levels, for example, contrarians believe that the market is at or near a bottom. That’s because any short-term traders who are likely to sell their stocks when conditions are unfavorable will have already dumped them — removing potential selling pressure that could drive the market still lower. The reverse is the case, the contrarians say, when optimism is extremely high.

Consider the sentiment that prevailed when the stock market hit a low in June this year. According to The Hulbert Financial Digest, investment newsletters that focused on timing the stock market’s short-term trend recommended, on average, that their subscribers allocate 88 percent of their equity portfolios to cash and the remainder to shorting the stock market — an aggressive bet that stocks would fall further. Far from declining, of course, the Dow Jones industrial average is now almost 1,500 points higher.

By Nov. 24, by contrast, the average recommendation of this same group of newsletters had changed greatly — to allocating nothing to the short side of the market and 71 percent to the long side. Though the newsletters cut their average recommended exposure by 12 percentage points on Thursday, to 59 percent on the long side, the level is still very high — double the average since the bull market began in October 2002.

Contrarians appear justified in their worry about the high sentiment level. The digest recently compared the stock market’s average three-month returns after days with extreme sentiment readings (defined as the 10 percent of trading days when sentiment was highest and the 10 percent when it was lowest). In the three months after the most pessimistic days, the market gained 11.9 percent more, annualized, than it did after the most optimistic days.

Further support for contrarian analysis comes from a study published in the August issue of The Journal of Finance. Entitled “Investor Sentiment and the Cross-Section of Stock Returns,” its authors are Malcolm P. Baker, an associate professor of finance at Harvard Business School, and Jeffrey Wurgler, an associate professor of finance at New York University’s Stern School of Business.

The professors focused on those companies that economic theory suggests would be most vulnerable to investor sentiment: small-cap growth companies, which have relatively few assets and little or no record of consistent earnings. Traditional balance-sheet analysis provides relatively little insight into these stocks, so their valuations can be subjective, supported largely by investor enthusiasm. The professors studied the period from the beginning of 1963 to the end of 2001.

They found just what a contrarian would expect: after periods when sentiment was particularly high, like the months and years leading to the bursting of the Internet bubble in early 2000, small-cap growth stocks proceeded to perform very poorly. That makes sense, because investor enthusiasm would have bid the prices of these stocks to very high levels and made them vulnerable to even the slightest decline in that enthusiasm.

The reverse was the case after periods of low sentiment, the professors found. Small-cap growth stocks are punished particularly harshly when investors become discouraged, and from such low levels they can provide handsome subsequent returns.

WHAT about companies for which traditional balance-sheet analysis is more useful — larger companies, generally, and those in the so-called value category? The professors found that investor sentiment has relatively little effect on these stocks. That also makes sense, according to the professors, because such stocks’ valuations are less vulnerable to the way the sentiment winds are blowing.

Given this research and the current level of market optimism, there are a couple of strong implications for investors. First, it would be wise to take some money off the table and to build up some cash until sentiment drops to less-lofty levels. And, second, you might want to shift exposure away from small-cap growth stocks.

From weekend reading -- part 2:

How the Pros Tell If a Stock Is a Bargain by Gregory Zuckerman of the Wall Street Journal. Excerpts:

Are stocks cheap or expensive?

That's the key question on the heels of an impressive rally that has taken the Dow Jones Industrial Average up 14% this year. Most of the gains have come in just the past few months, although the benchmark took a breather last week, sliding 0.7%. (The Nasdaq Composite Index is up 9.4%, after losing 1.9% last week.)

Big gains sometimes elicit caution from market commentators, but they don't always mean that stocks are too expensive in relation to companies' earnings and business prospects. Similarly, this year's double-digit growth in corporate earnings doesn't necessarily mean stocks are attractive.

Investing pros use a group of financial ratios to figure out whether the market, and individual stocks, are cheap or pricey relative to company fundamentals. None of these formulas is enough on its own, but together they can help locate attractive companies.

Here's a look at five measures, which generally suggest that the stock market is reasonably priced, though not in bargain territory.

1. Price/Earnings Ratio
The ratio of a company's stock price to its per-share earnings is the granddaddy of investment metrics. Stockholders are the owners of a public company, so the stock value depends on the company's earnings. If a stock sells for $20 and the company earns $1 a share, the P/E ratio is 20. The higher the ratio, the more expensive a stock is in relation to its earnings.

It is best to compare a stock's P/E with that of industry peers as well as the overall market. If a company is trading at a relatively high P/E, it means investors have high hopes and are willing to pay up. That could work out well if the hopes are met, but any disappointments could send shares tumbling.

Academic research demonstrates that buying low-P/E shares is a recipe for success. Several years ago, Warren Buffett bought several Korean stocks when their P/E ratios reached low-single-digit levels; the stocks eventually climbed. Robert Howell, a professor at Dartmouth's Tuck School of Business, says he generally avoids stocks with P/E ratios above 20.

The market is somewhat attractive based on P/E. The Standard & Poor's 500-stock index, which tracks the largest companies, trades at a P/E ratio of 17.8 based on the past 12 months of earnings. That is lower than the average P/E range of 19.2 since 1980. ...

2. Price/Free Cash Flow
Rather than reported earnings, many successful pros focus on free cash flow, or the cash income that a company is left with after paying expenses. If a stock has a low ratio of price to free cash flow, that suggests it is a healthy business that has a lot of money left over for dividends, stock buybacks or other steps to improve a stock's return. ...

Stocks now trade at less attractive levels in relation to cash flows than they did earlier this year, but this year's figures are among the most attractive since 1996.

3. Price/Book Value
Book value is a measure of a company's assets minus its outstanding debt or other obligations. If a company's shares are worth $2 billion and its book value is $1 billion, then it is trading at two times book value.

A low price-to-book ratio can give comfort to an investor. That's because a company's book value can be a good starting point in estimating the firm's value in the event it had to be liquidated.

The S&P 500 currently trades at 3.1 times book value, about the level of the past few years though below the expensive level of about 4.5 in the late 1990s.

4. Price/Sales
Some pros like stocks with a lot of sales compared to their price, or a low price-to-sales ratio. So a company with shares worth $500 million and sales of $1 billion would have an attractive price-to-sales of 0.5.

But sales don't guarantee profits. So companies with low price-to-sales ratios should have a good plan to turn those big sales into earnings, or the stocks won't benefit.

Companies in the S&P 500 now trade at 1.5 times their sales, close to the level of recent years but above levels of the early 1990's.

5. Return on Invested Capital
Jack Ablin, chief investment officer at Harris Private Bank in Chicago, urges investors to focus on a company's so-called return on invested capital, or how much profit it generates from the amount it invests in its operations.

To get that figure, he divides a company's earnings (before interest and taxes) by total assets. On that basis, he says engine maker Cummins (CMI) is attractive.

Harry's note: Apparently the story ended here, without a conclusion. Maybe the conclusion is prices are line? To read the piece, click here.

Skype explodes: Businesses are now using Skype to talk to their people around the world. Imagine you're traveling in Europe. You want to call your US office. Your hotel room has broadband. Bingo, plug in your headset and make free phone, free video and free conference calls to other Skype users anywhere in the world. Had you dialed on your hotel phone, you'd be looking at bills for hundreds of dollars -- often bigger bills than what your room cost.

Frankly, I'm staggered how fast business has accepted Skype. When I used it last night, there were five million people speaking on Skype.

This is my daughter, Claire, in her $20 Logitech stereo headset and her $200 sunglasses. She uses the headset and her laptop to make Skype calls. The Skype calls sound better than most landline calls and a heck of a lot better than all cell phone calls. She and her fiancée, Ted, are on a single Comcast cable modem in Boston. Last night, she was speaking to me in New York. And Ted was talking to a friend in Singapore. That meant her Comcast cable modem was handling two simultaneous Skype phone calls and doing so flawlessly. Amazing technology. For the $20 headphones click here. That will take you to the Cyberguys' main page. Then search for item number 1900482. To download the free Skype software for your PC or laptop, click here.

Buy Apple Stock
Apple Computer reported today that it has developed computer chips that can store and play music inside women's breasts.

This technology is considered to be a major breakthrough because women are always complaining about men staring at their breasts and not listening to them.

The old cowhand
An old cowhand came riding into town on a hot, dry, dusty day. The local sheriff watched from his chair in front of the saloon as the cowboy wearily dismounted and tied his horse to the rail. The cowboy then moved slowly to the back of his horse, lifted its tail, and placed a big kiss where the sun don't shine. He dropped the horse's tail, stepped up on the walk and aimed toward the swinging doors of the saloon.

"Hold on there, Mister," said the sheriff. "Did I just see what I think I saw?"

"Reckon you did, Sheriff. I got me some powerful chapped lips."

"And that cures them?" the Sheriff asked.

"Nope, but it sure keeps me from lickin' 'em."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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