I like to start with a broad view of the market when I prepare to evaluate investments. This helps me identify areas that may have opportunities. There are a myriad of financial instruments as investment posibilities to consider, and industries and sectors to consider. For example, stocks and bonds tend to decline in value during times of increasing interest rates but exceptions can be stocks of companies producing commodities that provide a hedge against inflation, such as precious metals mining companies.  Or the cyclical retail sector may not be where you want to buy stocks as we head into a recession - but you might like to sell them, even short.

So - where are we now? It is mid-October 2007 as I write this and the US economy has been growing steadily since a turnaround coinciding with tax breaks in 2002. This five-year growth period doesn't set any marathon records for the up side of the economic cycle, but there certainly have been shorter ones. Current indicators show the growth may be slowing.

The unsteady real estate and mortgage markets have investors concerned. Energy and commodities prices have increased significantly in recent years. Recent reductions in interest rates by the Fed may hold off recessionary pressures and keep the economy and real estate chugging along. There is a lot of discussion now about whether the risk is greater from inflation rearing its ugly head or from recession. 

The whole monetarist approach of walking the tightrope between recession and inflation is something I have never had a lot of confidence that the Fed could effectively carry out, but for about 25 years they have done it pretty well. Now we have a new leader with Bernake at the helm and I am skeptical again. This is a year or so ahead of a presidential election and the politics introduce another set of unknowns to the long-term prospects view. 

This is all to say that there is plenty of uncertainty about where we are in the business cycle - will this be a soft landing and go right back to long periods of growth, or do we have a full blown recession upon us? It makes a difference in evaluating opportunities. You can download a variety of economic data from the Federal Reserve Bank of St. Louis and analyze the trends in money growth, gross domestic product, interest rates, inflation, and employment for the US and several other countries. Sample data and charts are in Investing Part Two: Interest Rates, Gross Domestic Product, Money Growth.

One of the ways I like to evaluate stocks of companies I am considering investing in is to look at Price to Earnings ratios as an indicator of how the market values the company. No single ratio tells the story by itself, but PE ratio can be a good starting point to figure out what is going on a the company.

Lets use Google Finance to drill down to the company level. Their division of sectors and sub-categories is presented in Investing - Part Three: Business Sectors and Sub-categories. Within their Basic Materials Sector, let's go into the first sub-category: Chemical Manufacturing. When I looked (October of 2007) there were over 300 companies listed in the Chemical Manufacturing sub-category, but only 88 of them had meaningful P/E ratios (you can't divide the stock price by earnings per share on companies without earnings, so they don't get a PE ratio). Ratios ranged from a high PE of 617 for ADA-ES, Inc down to a low of 5.45 for OM Group. 

The very highest PE ratios (in any category) usually come from the mathematics of dividing a price per share by very small earnings. The price reflects an expectation that earnings will increase, which should bring the PE ratio down to a more reasonable level. Very low PE ratios are usually a result from an expectation of lower future earnings. This could be from pending lawsuits or bankruptcy, announced closures, entry of competitors, product obsolescence, and problems with management. By looking at what is going on with companies with both high and low PE ratios in an industry, you can get a feel for the pitfalls the mainstream companies need to watch out for and can benefit from avoiding. For companies with solid earnings, higher PE ratios generally come from expectations of continued earnings growth.