Don’t be fooled by the ‘stocks are cheap now’ argument. They’re not

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The stock correction, while dramatic, hasn’t really done a whole lot to make the market look more affordable.

In fact, valuations remain high by historical standards when looking over five- and 10-year periods. Normally, investors will go bargain-hunting when the market saw as sharp a dive as it has during February, but low-priced sectors are still hard to find.

As a group, the S&P 500 has fallen from trading at more than 18 times forward earnings to 16.3 times as of Friday. While that gets the index closer to its normal level, that still is a shade above the five-year average of 16 and considerably above the 10-year standard of 14.3, according to FactSet.

Looking inside the index, six of the 10 sectors are trading below the five-year average, with energy the only one meaningfully under, while only one is below the 10-year norm. (The real estate sector is too recent to track its history.)

While the correction has brought valuations more in line, most strategists aren’t recommending using the metric as a guide for buying.

“On a valuation basis, concerns remain,” John Stoltzfus, chief investment strategist at Oppenheimer Asset Management, said in a note to clients. “Valuations aren’t cheap though we’d suggest that they aren’t terribly rich considering six quarters of consecutive earnings growth as well as the relative valuations of stocks and bonds against prospects we see for reflation versus worrisome inflation.”

The comments reflect a growing dilemma in the markets: How do prices line up with high expectations for earnings balanced against worries over inflation?

This bull market that began 10 years ago next month has been dependent on what strategists call “multiple expansion” — the willingness of investors to pay higher prices compared with earnings, fueled by expectations that growth will continue.

Price-to-earnings sat a little above 10 in March 2009 and has been on a steady trek higher since around October 2011.

Valuations “have improved meaningfully with the recent decline in equity prices and improvement in [earnings] expectations,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets. However, “multiple expansion is unlikely with Fed tightening ramping up and given the late stage of the bull market.”

So rather than just looking for low multiples, the best bet for investors could be to find sectors that suffered the most during the correction.

Stoltzfus calls the group “babies thrown out with the bathwater” and advised clients to “stay tuned” for opportunities that will arise as market volatility continues.

Sam Stovall, the chief investment strategist at CFRA, advises a similar approach, looking for the sectors that took the biggest beating during the sell-off and drilling down for opportunities. Specifically, he said market history since 1990 shows that the three sectors and 12 sub-industries that lose the most during corrections will outperform in the six months ahead.

In this case, that means energy, health care and materials among broad sectors, while the three worst-performing sub-industries have been semiconductors, life and health insurance, and a tie between health care supplies and oil and gas exploration and production. For instance, though materials are still slightly expensive compared with historical norms, the sector’s 10.6 percent loss during the correction makes it attractive.

“Due to the swiftness of the sell-off, history says we should expect a quicker conclusion and more rapid recovery than normal,” Stovall said in a note.

Source

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