CNBC reports: “Nearly all corporate CFOs say … the stock market is overvalued.”
“The stock market is overvalued,” according to Allianz CEO Oliver Bate.
In fact, a report this month said that stock market valuations are stretched beyond what we saw during the dot-com mania by some measures.
And we all know what happened when that bubble burst. So it’s only natural to feel concerned.
But are conditions really that bad? And are there no opportunities to be found?
Well, let’s take a step back…
When evaluating the level of stock prices, I find it helpful to remind myself that there’s more than just valuations to consider.
Actually, there are three basic components that make up a stock’s return … and those are leading us straight to 2020’s big winners.
The Key to Understanding Stock Returns
You see, a stock’s return can be attributed to just three sources:
- Earnings: Did the company’s earnings per share grow or shrink?
- Valuations: Were investors willing to pay a higher or lower price-to-earnings (P/E) ratio for a stock?
- Dividends: If a company pays a dividend, what is the yield on the stock?
Take Microsoft Corp. (Nasdaq: MSFT) in 2019 for example.
The company’s earnings will have likely jumped 21% in 2019.
The P/E ratio went from about 24.3 to 31.6. That’s an increase of 30% in valuation multiples.
And Microsoft paid a dividend of $1.89 last year … which is good for a 1.5% yield on the stock.
Add it all up (21% + 30% + 1.5% + compounding dividend) … and Microsoft’s total return in 2019 was about 55%.
So with this in mind, are there any opportunities left in the market?
Ignore the Analysts … Look Here for Big Gains
Wall Street is sounding the alarm on a valuation bubble in stocks.
But I just don’t see it yet. When I look under the hood, I see huge opportunities for more profits in this bull market.
The chart below shows expected earnings growth for S&P 500 Index sectors in 2020.
Take a look at the health care sector.
Earnings: In 2020, this sector will have the second-largest increase behind the volatile energy sector. Earnings are expected to jump by 26%. This puts health care way ahead of the S&P 500.
Driving this increase is the explosion in spending across various health care categories. Total spending is projected to top $5 trillion in 2020. That’s up nearly 47% compared to just five years ago. And it’s not slowing down anytime soon.
According to the United Nations, the 65 and older age group is growing faster than any other. That will only create even more demand for health care … and more spending.
Valuations: The P/E ratio in the health care sector is only 15.9 times next years’ earnings, which is below the sector’s five-year average and well below the S&P 500’s ratio of nearly 19 times.
Dividends: The Health Care Select SPDR exchange-traded fund (NYSE: XLV) yields 2.1%, putting the three sources of stock returns on your side in 2020. It’s an easy way to profit from growing earnings and cheap valuations.
Best regards,
Research Analyst, The Bauman Letter
