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
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
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
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
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
There are a few ways to play the low PEG ratio and rising rate
It may be worth checking out the Technology Sector ETF (
). 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.
) and Sandisk (
) are Zacks Rank #1 stocks that have PEG ratios which are below
their median. Alliance Fiber (
) and Xilinx (
) are more expensive, but may also be worth a review.
ALLIANCE FIBER (AFOP): Free Stock Analysis
INTERSIL CORP (ISIL): Free Stock Analysis
SANDISK CORP (SNDK): Free Stock Analysis
SPDR-SP 500 TR (SPY): ETF Research Reports
SPDR-TECH SELS (XLK): ETF Research Reports
XILINX INC (XLNX): Free Stock Analysis Report
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