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Why a low price-to-earnings ratio isn't always a good thing

Think a low price-to-earnings (P/E) ratio is a good thing? Think again.

It's kind of like a reflexive action — a habit that is so deeply ingrained and conditioned in the minds of investors who pray at the altar of low P/E's that some just can't get away from it. It's not always a good thing, and you should understand why, because it can help you avoid value traps.

Investors can't seem to make up their minds about whether or not the economy is heading into a recession or is starting to heat up. The usual suspects, widely regarded indicators, are sending out mixed signals. And stock valuations have been distorted by buybacks and other forms of financial engineering. That's why now, more than ever, it is critical to understand what the price-to-earnings ratios of the major sectors are telling us.

Traders work on the floor of the New York Stock Exchange.
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First, does everyone reading this know what a P/E ratio is? Quick definition: Share price of a stock divided by its earnings per share. It is the most commonly used value metric in the market.

The mistake is when one compares the P/E ratio of an individual stock to the P/E of the overall S&P 500, because the latter is only an average. If the S&P 500 has a P/E of 16, for example, one may look at a stock with a P/E of 8 and think they are onto a real bargain. Maybe, maybe not.

The P/E ratio is different for different sectors, which makes comparing any stock to any ratio other than that of its sector a potentially misleading signal.

Sharing a little lesson from the 2008/2009 market crash, I recall pundits saying the stocks of homebuilders were cheap because their average P/E was half that of the overall S&P 500. Yet these stocks, which fall within the financial sector, got smoked despite their supposed cheap valuations. If these people only knew that homebuilders have always typically had below-market P/E's as a way to compensate investors for interest-rate risk.

There are two kinds of risks: systemic and sector. The former is the risk that all companies share to a large extent. As a shortlist, these could be recessions, political, regulatory and demographics. The latter, sector risks, as the name implies, are risks that are unique to certain sectors.

There are 10 sectors of the U.S. economy, or GICS (General Industry Classification Standards), as determined by Standard & Poor's. Here is a broad overview of each sector, their unique sector risks, and if they typically have a P/E above or below the S&P average P/E.

Sector sense

  1. Financials: Typically lower than S&P average to compensate investors for interest-rate risk.
  2. Energy: Typically lower than S&P average to compensate investors for commodities risk of changing supply and demand.
  3. Utilities: Typically lower than S&P average to compensate investors for interest-rate risk, though the ultralow yields in recent years have distorted this average.
  4. Communications: Typically lower than S&P average to compensate investors for interest-rate risk, though the ultralow yields in recent years have distorted this average.
  5. Materials: Typically lower than S&P average to compensate investors for commodities risk of changing supply and demand.
  6. Industrials: Typically below or similar to S&P to compensate investors for recession risk.
  7. Health care: Typically similar to S&P 500 to compensate investors for regulatory and patent expiration risks but are valued for their steady earnings growth and recession-proof qualities.
  8. Consumer staples: Typically similar to or greater than S&P and are valued for their steady earnings power and recession-proof qualities.
  9. Consumer discretionary: Typically greater than S&P 500 but can move well below and beyond that due to risk of changing consumer tastes.
  10. Technology: Typically above S&P for growth tech company (some have super high P/E's) and below S&P for mature tech companies. Risk is obsolescent.

Keep in mind that this is a shortlist and there are lots of other risks and benefits that these sectors offer investors, which is why diversification is something I feel strongly about.

"Investors can't seem to make up their minds about whether or not the economy is heading into a recession or is starting to heat up. ... That's why now, more than ever, it is critical to understand what the price-to-earnings ratios of the major sectors are telling us."

The usefulness of this is to help you better gauge what is a meaningfully low or high P/E ratio.

Consumer staples, while typically rewarded for their consistent earnings growth and steady dividends, seem to be trading a little rich lately. Yet P/E's of banks, which are typically lower than that of the overall market, are trading at lower-than-normal ratios. Of course, this has to do with concerns over energy loans and worries of deflation.

Today, the safe dividend plays are trading like high P/E growth stocks, according to many of their P/E ratios. With a stock that is above its sector-usual ratio, you really have to be prepared to hold through a full economic cycle. You have to decide if you like a stock enough to know in advance that it's near and intermediate move higher is in the rearview mirror.

The general lesson right now is that lots of valuation metrics are out of whack due to a confluence of concerns.

Just remember that comparing the P/E of a particular stock to the S&P 500 is helpful, but keeping in mind the typical history of the extent to which the P/E of its sector is usually over or under the S&P 500 P/E is much more useful.

S&P 500 sector P/E's

Sector
Latest
10-Year Average
High
Low
S&P 500 15.7 13.9 17.4 9.5
Consumer Discretionary 17.0 16.5 27.2 12.1
Consumer Staples 20.4 16.0 20.4 11.2
Energy 44.9 13.3 44.9 5.9
Financials 12.0 12.3 17.6 7.8
Health Care 14.6 13.9 17.9 9.3
Industrials 14.9 14.4 16.9 8.5
Information Technology 15.0 14.9 20.6 10.4
Materials 15.7 14.6 22.8 8.5
Telecommunication Services 13.2 14.5 19.6 9.0
Utilities 16.7 14.2 18.1 9.1

(Source: Yardeni Research, Thomson Reuters consensus estimates)

By Mitch Goldberg, president of ClientFirst Strategy

Follow Mitch and read more of his market commentaries here.