Today’s stretched valuations and low market volatility leave stocks – especially those in more expensive market segments – vulnerable to bad news. So, Russ suggests investors adopt a value bias, focusing on two market segments that offer good relative value.
As evident in last Thursday’s European-bank related market jitters, today’s stretched valuations and low market volatility leave stocks vulnerable to bad news, even when the news is relatively minor as was the case last week.
Market Realist – The markets seem to demonstrate stretched valuations, a fact endorsed by the Federal Reserve in its recent report. “Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year,” the Fed said in its biannual report. According to data compiled by Bloomberg, the S&P Smallcap 600 Index (SML) was trading at 26x reported profit whereas the Nasdaq Biotechnology Index (IBB) exhibited a multiple of more than 500—giving credence to Fed’s concerns. On July 15 2014, the S&P 500, as tracked by iShares Core S&P 500 ETF (IVV), had a price-earnings (or PE) ratio of 18—the highest level since 2010.
Market Realist – The CBOE Volatility Index (or VIX) is a popular measure of stock market volatility based on options prices. As the previous graph shows, VIX, as tracked by S&P 500 VIX Short-Term Futures ETN (VXX), has been hovering near lows not seen since March, 2013. VIX was down almost 16% in May, 2014. Volatility has been low across stock, bond, foreign exchange, and commodity markets. Although a rebound in volatility was witnessed in the second week of July, both the U.S., VIX, and European benchmark options, VStoxx, are still down more than 5% this year as the Fed and European Central Bank echoed commitments to accommodative monetary policy. Stretched valuations and low volatility levels leave stocks susceptible to unexpected events. Both positive and negative surprises could be a jolt to the system.
And equities in the more expensive market segments are particularly vulnerable. Case in point: U.S. small caps, biotech and Internet stocks suffered the most last week, and these are among the areas of the market where stock performance is most outpacing fundamentals.
Read on to find how investors can find value in two market segments.