As I mentioned in last Friday's Chart Advisor newsletter, banks and stock markets in China and much of Asia will be closed for the Spring Festival or Lunar New Year holiday. This week marks the beginning of the Year of the Pig. This reminds me of the stock traders' adage "pigs get fed, and hogs get slaughtered." The saying is supposed to make the point that profit-seeking investors (pigs) can be successful over the long term, but overleveraged and inconsistent traders (hogs) will implode.
Evaluating the current market environment for signs that the hogs are getting out of control is a good exercise. Analyst expectations for earnings in the first quarter of 2019 are near 0%, which could be another underestimate, but it certainly indicates a situation where appropriate judgment and discernment is important.
An area of concern for me right now is valuations in the "defensive sectors." For example, I ran an analysis today of the 50 largest stocks in the U.S. utilities sector, and the average P/E ratio was 27, which is up from 23 in 2014. To put that in perspective, the average P/E ratio across the S&P 500 has recently fallen to 20.85. Does it make sense that utilities should be one of the most highly valued sectors in the market?
For most sectors, a high P/E ratio is a function of growth expectations. In other words, sectors that are growing tend to have high earnings multiples because profits are expected to rise quickly in the future. Therefore, in most cases, a high P/E ratio is not particularly worrisome.
However, high growth rates and utilities do not usually go together. In my opinion, investors should be as picky as possible when considering the value of individual sectors to avoid the hogs. As you can see in the following chart of the Utilities Select Sector SPDR ETF (XLU), there is a key pivot level at $55 per share that, if valuations are already too extended, may be setting investors up for failure.
Alphabet Inc. (GOOGL)
The counterpoint to the defensive sectors, which seem overvalued, are the other groups that have likely been oversold during the market decline at the end of 2018. Technology is one of those sectors that seems likely still undervalued. For example, Alphabet Inc.'s (GOOGL) earnings were released this afternoon and were above expectations ($12.77 per share vs. $10.86 estimated), which is another positive surprise in a sector that suffered some of the worst selling during the previous market decline.
Alphabet is an important stock because most of its revenue and profitability is derived from advertising. If the consumer and business economies are doing well, then advertising rates are strong and Alphabet's earnings will be positive. This is often one of the first places we can detect underlying weakness in the economy if advertising spending rates are flat or negative.
The bottom line is that, even if Alphabet stock is trading lower after the close on rising costs and lower margins (see chart below), the top- and bottom-line numbers should be supportive for the sector. I wouldn't be surprised to see prices rise again in tomorrow's session once investors have had a chance to digest the data.
Risk Indicators – The Week Ahead
Most risk indicators are still signaling that there is little cause for concern in the near term across the broader market indexes. The bond, gold, small-cap and volatility indexes were all still headed the right direction today as the S&P 500 rallied. I was further encouraged by the improvement in the positioning of traders in the currency market. Although it isn't always a topic for financial headlines, safe haven currencies like the Japanese yen usually fall when risk appetite is rising. Although the yen didn't decline very much in January, it is just starting to inch beyond short-term technical levels that should be supportive for higher stock prices.
Although this can be confusing for non-forex traders, the chart below illustrates the amount the yen has fallen in value over the past two trading days against the U.S. dollar. When the chart is rising, that means it costs more weaker-yen to "buy" a dollar. A rising USD/JPY exchange rate is usually correlated with improving stock prices, and a falling USD/JPY rate can provide early warning signs of weakness.
The Bottom Line
Bonds, stocks and risk indicators seem to be pointing the right direction for additional gains in February. However, using discretion when evaluating the relative risk of some traditionally "defensive" sectors is likely to be important for investors trying to maximize their profits and avoid the hogs.
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