Bargain Hunters, Beware
Selloffs are a great time to look for bargains─with one caveat: They make all stocks look cheap, increasing the risk that your bargain is really an overpriced bust. That's even more true after Monday's market rout.
Stocks, of course, are cheaper than they have been since September 2010: The Dow Jones Industrial Average has dropped about 16.4% since peaking in April, while the Standard & Poor's 500-stock index has dropped about 18.3% since its peak. Valuations are cheaper than they have been all year: The S&P 500's price/earnings ratio, which is calculated by dividing the current market price by the total profits of the companies in the index, is currently about 10.07, based on 2012 earnings estimates.
One month ago it was over 12.
Yet the uncertainty about the economic environment makes it difficult to trust those valuation numbers. Part of the problem is that most widely cited measures of P/E are based either on analyst forecasts, which tend to be overoptimistic, or the previous 12 months' profits, which have been particularly good times for company earnings.
Right now, analysts expect the companies in the S&P 500 to earn $114 per share in 2012, according to Adam Parker, head of U.S. equity strategy at Morgan Stanley. But at, say, $100, the P/E would be about 11.5─not so cheap after all. Mr. Parker recommends investors wait for analysts to start change their forecasts before jumping in.
So where should bargain-hunters start their search?
While at least three sectors are trading below their historical P/Es, two of them─tech and energy─are likely to cause investors more pain, says Savita Subramanian, head of quantitative strategy at Bank of America Merrill Lynch. That's because their prices are falling faster than their earnings, meaning that, like the S&P 500, they're not as cheap as they look.
Health-care stocks, on the other hand, have prices that are rising relative to the S&P 500, while earnings expectations are holding up better than the overall market. That sector may be a good place to start looking for bargains.
But investors must be careful. Even among individual stocks, the selloff hasn't created as many good deals as one might think. Morningstar Inc., for instance, ranks only 28 of the 289 U.S. stocks with market caps above $10 billion with five stars, meaning that they believe only about 10% of stocks currently trade below what it deems fair value. That list includes health-care stocks like WellPoint Inc. and Abbott Laboratories, and tech giant Hewlett-Packard Co.
Just because a stock is cheap doesn't mean it's cheap enough to buy. 'We're always looking for stocks with good valuation metrics,' says Jim Holtzman, an adviser at Legend Financial Advisors in Pittsburgh. 'But we're waiting to see where this all takes us.'
Stocks, of course, are cheaper than they have been since September 2010: The Dow Jones Industrial Average has dropped about 16.4% since peaking in April, while the Standard & Poor's 500-stock index has dropped about 18.3% since its peak. Valuations are cheaper than they have been all year: The S&P 500's price/earnings ratio, which is calculated by dividing the current market price by the total profits of the companies in the index, is currently about 10.07, based on 2012 earnings estimates.
One month ago it was over 12.
Yet the uncertainty about the economic environment makes it difficult to trust those valuation numbers. Part of the problem is that most widely cited measures of P/E are based either on analyst forecasts, which tend to be overoptimistic, or the previous 12 months' profits, which have been particularly good times for company earnings.
Right now, analysts expect the companies in the S&P 500 to earn $114 per share in 2012, according to Adam Parker, head of U.S. equity strategy at Morgan Stanley. But at, say, $100, the P/E would be about 11.5─not so cheap after all. Mr. Parker recommends investors wait for analysts to start change their forecasts before jumping in.
So where should bargain-hunters start their search?
While at least three sectors are trading below their historical P/Es, two of them─tech and energy─are likely to cause investors more pain, says Savita Subramanian, head of quantitative strategy at Bank of America Merrill Lynch. That's because their prices are falling faster than their earnings, meaning that, like the S&P 500, they're not as cheap as they look.
Health-care stocks, on the other hand, have prices that are rising relative to the S&P 500, while earnings expectations are holding up better than the overall market. That sector may be a good place to start looking for bargains.
But investors must be careful. Even among individual stocks, the selloff hasn't created as many good deals as one might think. Morningstar Inc., for instance, ranks only 28 of the 289 U.S. stocks with market caps above $10 billion with five stars, meaning that they believe only about 10% of stocks currently trade below what it deems fair value. That list includes health-care stocks like WellPoint Inc. and Abbott Laboratories, and tech giant Hewlett-Packard Co.
Just because a stock is cheap doesn't mean it's cheap enough to buy. 'We're always looking for stocks with good valuation metrics,' says Jim Holtzman, an adviser at Legend Financial Advisors in Pittsburgh. 'But we're waiting to see where this all takes us.'
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