Given the recent sell off, it might be worth looking for value in the market. If you are like me, it seems easier to embrace stocks with a value proposition in a shaky market. In the hunt for value, each major sector of the market was evaluated using its PEG ratio. The PEG ratio is the price to earnings ratio divided by the growth rate in earnings. The PEG ratio was chosen because the S&P 500 is trading near its average PE ratio, but global growth is slow. As a result, it may be worth examining sectors relative to their growth rate. Looking at the PE ratio alone may not tell enough of the story. A PE ratio could be low because of slow growth and provide a deceptive picture of valuation. Financial shares and utility shares are notorious for having low PE ratios, but could still present opportunity.
Don’t let the table intimidate you:
The table following displays the average and median PEG ratios for major sectors between May 1999 and July 2013. It also contains the standard deviations of the PEG ratios, and difference of the PEG ratios from their averages divided by their standard deviations. The difference of the PEG ratio from average divided by the standard deviation is called the Z-score. The Z-score indicates how far the PEG ratio is from average in standard deviations. Standard deviation can be thought of as dispersion from the average.
The Z-score may seem like an awkward concept, but stay with me. The Z-score helps to standardize the difference of the PEG ratio from average for each sector. For example, the energy sector’s Z-score is -0.32. This indicates that the energy sector’s PEG ratio is 0.32 standard deviations below its average. In contrast, the healthcare sector’s Z-score is 2.21. This Z-score suggests that the PEG ratio for healthcare is 2.21 standard deviations above its average. The PEG ratio is higher less than 2% of the time.
Ideally, value would be most present if the sector was priced at a substantial discount to its average PEG ratio. Z-scores of less than -1.0 would be very attractive and anything less than -2.0 would in theory allow plenty of room for multiple expansion and higher prices.
The reverse is also true. Z-scores over 1.0 would suggest the sector is expensive to its average and values above 2.0 would, in theory, leave the sector vulnerable to multiple contraction and lower prices.
Where is the value?
Based on recent history, the technology and energy sectors are trading at a discount to their average PEG ratios and carry a PEG ratio which is low compared to the group. In contrast, healthcare and consumer staples are trading at the largest premiums to their average PEG ratios and high to the group.
Simple analysis suggests that investors are paying up for healthcare and staples and creating poor valuation in the sector. This is probably a function of the slow growth outlook. In contrast, a slow growth outlook is pressuring the PEG ratios in theenergy and IT sectors.
The market’s price structure is not surprising given the growth outlook. This is further confirmed by the utility sector which tends to be defensive. The utility sector tends to grow slowly and pay a dividend. Notice that its PEG ratio is comfortably above average with a Z-score of 0.87.
Notice consumer discretionary is priced at a PEG ratio below average. This also suggests that the market is cautious about economic growth. The trade is not paying up for growth in the consumer sector which makes sense given the outlook for reduced refinance activity, slow wage growth, and a relatively low savings rate.
Which sector is best correlated to interest rates?
Given the focus on Fed taper and a rising interest rate environment, it may be worth investigating which sector is most sensitive to interest rates. The table following displays the correlation between the price of each major market sector and the yield on the 10 year treasury yield.
How to read the table:
Correlations range between -1.0 and +1.0. A value of -1.0 indicates an exact inverse relationship, while a value of +1.0 indicates an exact positive relationship. A value of zero argues for no relationship. Thus, a negative correlation close to -1.0 suggests the sector price falls as interest rates rise, while a positive value close to +1.0 suggests the sector price rises as interest rates increase.
The financial sector tends to perform best in a period of rising interest rates with a correlation of +0.605. The telecom service sector is next best with 0.520. Note that technology performs well with a correlation of 0.258. Thus, if you think interest rates are likely to continuing rising, these sectors may be strongest performers, at least on a relative basis. Banks like rising rates because higher rates tend to increase net interest margins.
The worst performing sectors in a rising rate environment are consumer staples, materials, and energy. Surprisingly, utilities are fourth on the list.
Healthcare has a small positive correlation to the direction of interest rates along with consumer discretionary. The latter is surprising as consumer discretionary might be tied to refinance activity and the cost of financing consumption.
Technology appears to be the most attractive sector based on this analysis. Not only is it trading with a cheap PEG ratio to its history and relative to other sectors, its price direction tends to be positively correlated with interest rates. A rising rate environment should not be a macro headwind. One may get the added benefit of budget flushing at year end and the chance for consumers to purchase technology products during the holidays.
Consumer staples appear to be the riskiest sector. This sector is trading at a high PEG ratio relative its history and other sectors, and also tends to perform poorly in a rising rate environment.
There are a few ways to play the low PEG ratio and rising rate theme:
It may be worth checking out the Technology Sector ETF (XLK - ETF report). This is a generic way to play the inexpensive valuation in technology sector, while finding some insulation against higher interest rates. The sector is just off its recent high, but may be worth watching.
There are a number of Zacks Rank #1 (Strong Buy) stocks in the technology sector. These companies are Zacks Rank #1 because their earnings estimate revisions are heading higher. Thus, they have a bottom up story which could complement the valuation and interest rate theme.
Intersil (ISIL - Snapshot Report) and Sandisk (SNDK - Analyst Report) are Zacks Rank #1 stocks that have PEG ratios which are below their median. Alliance Fiber (AFOP - Snapshot Report) and Xilinx (XLNX - Analyst Report) are more expensive, but may also be worth a review.