Cheap Stocks Do Still Exist, No Matter What The Headlines Say

Cheap Stocks Do Still Exist, No Matter What The Headlines Say
Carl Hazeley

almost 3 years ago3 mins

Mentioned in story

What’s going on here?

US stocks may have hit yet another record high this week, but Bank of America’s monthly fund manager survey showed on Tuesday that most professional investors are still pretty positive about markets. Perhaps that’s no surprise, given the pockets of value I’ve been able to turn up myself.

What does this mean?

In absolute terms, US stocks are expensive: the S&P 500 index is currently trading at a forward price-to-earnings (P/E) ratio of 22x, way up in the 96th percentile compared to its history. By some measures, US stocks are even more expensive now than during the dotcom bubble. Back then, the median S&P 500 stock had a P/E ratio of 14x – today, it’s at 21x.

NTM = next twelve months (forecast earnings)
NTM = next twelve months (forecast earnings)

But stocks don’t exist in a vacuum, and low interest rates have played a major role in driving up their prices. If you compare the S&P 500’s valuation to interest rates, US stocks are currently only in the 40th percentile versus history – suggesting there’s still room for valuations to rise further.

How might that happen? In my view, stock market sectors that are relatively undervalued at present may hold the answer.

Defensive industries like consumer staples, communication services, and healthcare are all currently trading near their lowest-ever levels compared to both their own histories and the S&P 500 overall. The P/E ratios of these three sectors are respectively 6%, 22%, and 23% below the S&P 500’s present P/E ratio – the biggest discount to the index on record going back 30 years.

Even more eye-catching is the fact that US tech stocks also screen as attractively priced right now. Following the recent Nasdaq selloff, “info tech” stocks are only 16% more expensive than the S&P 500 in general, a figure which ranks in the 45th percentile historically.

The table below illustrates all this in a few ways. The first two columns show each sector’s two-year forward P/E ratio and compare it to the past 30 years. The second pair look at their current valuation premium (or discount) to the market and put that in a historical context. And the final two columns compare each sector’s “earnings yield” to the return offered by US 10-year government bonds, again relative to the past.

S&P sector valuation vs market and history

Why should I care?

Headlines stating US stocks are at their most expensive ever are just that: headlines. Absent any detail or context, you might be tempted to sell your entire “overpriced” investment. But apply a long-term analytical lens, and you might just decide that individual industries and companies actually look rather attractive – and that they may warrant further investigation as potential opportunistic additions to your portfolio.

The importance of looking beyond headlines obviously applies on this level too. Defensive sectors like consumer staples and communication services probably should be underperforming the broader market right now. People buy these companies’ products and services whatever the economic weather: that makes them stable investments in a downturn, but equally unexciting in a recovery. People aren’t much more likely to buy a second broadband subscription than they would be ordinarily.

The same is true of healthcare stocks in theory – but that’s a sector where deep-dive research possibly could unveil interesting investment avenues. Compared to other defensive sectors, healthcare stocks have historically delivered higher earnings growth – and some analysts have put their current valuation contraction down to political uncertainty.

The opportunity, then, may lie in identifying stocks that could outperform in this recovery when most investors are expecting they won’t. The global focus on health spawned by the pandemic could be one catalyst – and the virus itself could be another. Take Pfizer: the drugmaker said last week that between variant strains and the potential need to issue annual top-ups, there was significant room to hike its coronavirus vaccine prices.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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