At today’s prices, even the widest-eyed permabull is going to have a hard time arguing that U.S. stocks are “cheap.” With the S&P 500 trading at a trailing P/E ratio of 19.6, about the best argument you can make is that stocks are priced more or less in line with the average of the past 20 years.
That’s not exactly a rousing endorsement. And when you look at the cyclically-adjusted price/earnings ratio (“CAPE”), the story actually looks a lot worse. The S&P 500 trades at a CAPE of 27.2, or nearly 64% above its long-term average. This is about on par with its valuation in 1929 and 2007…before two of the worst market crashes in U.S. history.
For the broader market to continue its advance, one of two things needs to happen. Either earnings growth needs to massively accelerate, or investors have to get comfortable with bubble valuations on par with those seen in the 1990s. With earnings already near all-time highs…and with most of the world economy looking shakey…it’s hard to see a major acceleration of profit growth happening this year. And while we can never rule out a 1990s-caliber stock bubble, that’s not exactly something I want to bet on, particularly with the Fed now effectively out of ammunition.
But while the broader market is looking stretched these days, there are definitely some pockets of value to be found. And one area that really stands out at today’s prices is the energy sector.
Of the 10 industrial sectors that make up the S&P 500, energy is the cheapest by a wide margin, trading at a CAPE of just 13.8. That’s roughly half the CAPE valuation of the S&P 500 as a whole. As a point of reference, the consumer discretionary, health care, and technology sectors trade at CAPEs of 39.1, 31.5 and 28.8, respectively.
To be fair, some sectors—notably consumer discretionaries and technology—deserve to trade at a premium to the broader market, as they tend to have fatter profit margins and faster growth rates. But Big Oil is not exactly a profit slouch. The two biggest heavyweights in the sector, ExxonMobil and Chevron, consistently generate returns on equity in the high teens and above, with very few exceptions.
As of this writing, I do not have a position in ExxonMobil or Chevron. But in my Dividend Growth portfolio, I do have a large allocation to the energy sector. Between energy majors and pipeline MLPs, more than 25% of my portfolio is now allocated to energy. I like to invest my money where it is treated best, and right now many of the best names in this space are trading at 20%-50% discounts to their 2014 highs and offer some of the highest dividend yields in the world.
Am I concerned about falling energy prices?
No, I’m not. Big Oil has proven over the years that it is more than capable of making money in both bull and bear markets in energy. Frankly, the sector had gotten sloppy in recent years in some of its capital allocation decisions. There is nothing like a good crude-oil crash to make management focus on building shareholder value.
Meanwhile, the sector offers dividend yields of 3%-6% after the slide in share prices. I fully expect dividend growth to slow over the next two years, but I’m not expecting a wave of dividend cuts, or at least not among the blue chips in the sector.
We can’t control market prices. But we most certainly can be selective with what we buy, and today the best values in the world are in the energy sector.
