How to Find Opportunities When Market is Overvalued?

The Market (Dec. 2020) is Overvalued

Even though millions of people in the US are hoping for another COVID-19 relief to save them from eviction and poverty, it is pretty obvious that the current (US) stock market is overvalued. The chart below shows that the price/earnings (PE) ratio of the S&P 500 has reached the third highest level in history (37.32 to be exact) and keep rising.

S&P 500 Earnings & PE Ratio

Since PE is the ratio between price of a stock and its earnings per share, a decrease in earnings mathematically would push up PE if price remains unchanged or decreases at a slower rate than that of earnings.

However, this explanation needs to be taken with a grain of salt because it can’t explain why the price movement of those stocks failed to match the decline in earnings.

If you focus on the patterns of EPS and PE ratio in the above chart, you may notice that there seems to be a time gap between the two. So, I moved PE ratios 2 years forward and redrew the chart. This is what I got.

S&P 500 EPS and PE Ratios of 2 Years Later
S&P 500 EPS and PE Ratios of 2 Years Later

This new chart suggests that it takes time (approximately 2 years) for the general market to fully digest and respond to earnings performance (though sophisticated investors on the other hand may move much earlier), or that it takes time for information to reach (some) investors.

Here is how a typical bubble is formed. During periods of economic growth, slowly attract more and more new (inexperienced) investors to blindly enter the market because they don’t want to miss the opportunity to get rich fast. This movement could reach to a point where even kids can name a few popular stock names.

The demand brought by the new investors drives up prices and PE ratio. When the demand inevitably declines (due to either limited population of investors or the fact that prices in the market become too prohibitive to buy), the early investors start to sell off and prices drop. This in turn triggers panic among those who enter the market late and motivate them to also sell off in order to stop losses.

So, from the perspective of value investing, how to stay ahead of the curve of the market is important for investors to manage risk.

An Overvalued Market ≠ Everything Is Overvalued

An overvalued market doesn’t necessarily mean everything is overvalued. It simply means that it’s more difficult to find good investing opportunities.

Our earlier articles How Business Cycle Works with Value Investing and Patterns of Price/Earnings Ratios among Sectors and Company Sizes shown that not only sectors follow different patterns of price movements over time but also other factors such as company sizes also affect price movements.

Where to find values?

The following tables present conditions of 11 sectors in the US market on December 19, 2020. Table 1 shows that energy and utilities sectors have the lowest trailing PE ratios, 17.83 and 27.58 respectively.

Regarding profitability, even though it’s unfair to compare profitability among sectors (because of differences in the nature of businesses), but it is interesting to note that energy and utilities also have the highest returns on assets in the group and that utilities sector has the fourth highest profit margin. The energy sector is expected to recover slowly as oil price bounces back in the longer term.

Table 1. Value and Profitability Indicators
SectorsTrailing PEProfit MarginReturn on Assets
Energy17.83-0.250.09
Utilities27.580.110.03
Communication Services37.500.050.00
Financial47.820.220.01
Healthcare61.40-0.21-0.22
Materials63.47-0.030.01
Consumer Cyclical73.61-0.070.02
Industrials82.02-0.020.02
Real Estate86.050.240.01
Technology86.330.21-0.02
Consumer Defensive207.620.000.02

Regarding dividends, another important source of income for investors, Table 2 shows that real estate and energy are the top two sectors (averaging 7% and 6% respectively). Nonetheless, since energy sector has much lower (only 20%) PE ratio than real estate sector, the same amount of money can buy more earnings and dividends in the former than the latter.

With that said, real estate and energy sectors also have high payout ratio, meaning it’s relatively unlikely for them to raise dividends in the near future.

In comparison, other sectors may have more potential for dividends growth, but their PE ratios are too high to be considered undervalued.

Given that the current divide yield for S&P 500 stocks is only 1.59%, utilities sector with 3% dividend yield and 72% payout ratio seems to have a good balance between dividend yield, potential of growth, and valuation.

Table 2. Dividend and Debt Indicators
 Dividend YieldPayout RatioCurrent RatioDebt Ratio
Energy0.061.841.140.61
Utilities0.030.721.190.68
Communication Services0.030.310.820.65
Financial0.040.597.440.72
Healthcare0.000.030.380.47
Materials0.020.420.550.57
Consumer Cyclical0.050.310.720.71
Industrials0.020.420.670.60
Real Estate0.071.471.180.62
Technology0.010.130.590.55
Consumer Defensive0.020.280.740.61

Lastly, debt level is key to a company’s financial health regardless of profitability. Similar to profitability, debt levels differ among sectors. For instance, it’s normal for financial companies to borrow lots of money for their operation. But, overall, lower debt levels are preferred.

Current ratio in Table 2 measures how much short term debt (debts to be paid in a year) a company needs to pay comparing to its current assets (assets that can be sold for cash in a year). In comparison, debt ratio measures the level of total debt of a company comparing to its total assets.

Utilities, real estate, and energy sectors are on top of the list for current and debt ratios. Although they all have quite high levels of short-term debt (note, they do require large amount of capital for investment in infrastructure and construction), but their total debt levels are normal comparing to other sectors.

Conclusion

In today’s overvalued market, the utilities sector seems to be the best place for value investors to look for opportunities. Not only is the sector most undervalued among all sectors giving investors the biggest bang for the buck, it has reasonably high dividend yield and potential for growth. Most importantly, as a market correction could happen at any time, utilities is one good choice to hedge this risk. To add another layer of protection, give priority to larger companies with lower debt ratios.

At Sprout Stocks, we will soon offer visitors tools to filter stocks based a dozen criteria in multiple international stock markets. Make sure follow us on social media and check back soon.


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