As we highlighted yesterday, stock valuations jumped again in December to another cycle high. As the first two charts show, the cyclically adjusted P/E multiple has only been higher on several occasions and the median stock is trading at a record price to cash flow multiple as far back as we have data. These high valuation levels leave stocks at risk.
Compounding the risk of high valuations is the fact that world economies and financial markets continue to exude deflationary signs, which if anything are intensifying. As the below charts show, we have our World CPI Proxy at the lowest level since 2009, crude, copper, iron ore and commodity prices in general plunging, global government bond yields making new all-time lows, the US yield curve flattening and TIPS implied inflation expectations at the lowest level since the equity selloff in 2011.
High stock valuations and growing signs of deflation pose all sorts of risks to portfolios, so an important question is what kind of asset allocation is likely to mitigate some of those risks? Specifically for stock investors, what kind of stocks will tend to outperform in periods of deflation/disinflation, and at least on a relative basis, which of these groups offer some semblance of value?
To address the first question we've plotted the relative performance of a few developed market sector indexes (blue line, left axis) overlaid on the reciprocal of the US 10-year treasury yield (red line, right axis) such that higher numbers are equivalent to lower yield. What we find is that the three sectors whose relative performance has the the highest correlation to yields are Consumer Staples, Health Care, and Information Technology. As deflationary tendencies rise we would expect these sectors to outperform the broad equity market, and they have. Since the beginning of 2014 when yields began to fall precipitously these sectors have outperformed the broad equity market by 10-20%.
Now to address the valuation question, what stocks in these groups offer at least a little valuation protection - keeping in mind of course that valuations are stretched in general? To answer that we've shown below our proprietary valuation scores at the sub-industry level for each of these sectors. Our value scores take into account company valuations relative to earnings and cash flow growth, valuations relative to their own history, and cyclically adjusted valuations, among other factors. The score range is 0-100 with higher numbers indicating more relative valuation protection.
What we find is that on a relative basis most sub-industries in these sectors offer average to below average valuation protection, but only a few areas are egregiously overvalued. These include Distillers & Vintners, Health Care Technology, Biotechnology, and Semiconductor Equipment. On the other hand, there are a number of areas that, despite the outperformance in recent years, have not priced themselves out of candidacy for new buys. Some of these areas include Food Distributors, Food Retail, Personal Products, Health Care Services, Health Care Equipment, Pharmaceuticals, Technology Hardware Storage & Peripherals, Home Entertainment Software, and Systems Software.
Consumer Staples Value Scores by Sub-Industry:
Health Care Value Scores by Sub-Industry:
Information Technology Value Scores by Sub-Industry: