One of the biggest surprises in the stock market lately has been just how widespread gains have been across the universe of stocks. Yet the result has been an increase in risk in some unusual areas of the market, and investors should be aware of those danger signs in choosing stocks going forward.
The stock market continued to press modestly higher on Monday morning, adding to last week's gains as investors remained confident in the power of the U.S. economy to push corporate America higher regardless of global economic strains. As of 11:10 a.m. EDT, the Dow Jones Industrials (DJINDICES:^DJI) were up another 46 points, although broader market measures were mixed as markets weighed the potential for a return to volatility.
Where stocks are strongest -- and most dangerous
One particularly unusual element of stock market returns lately is where the areas of strength have been found. As the market has climbed, many conservative investors have gravitated toward traditionally defensive stocks in industries such as consumer goods. The reason is simple: Even when the economy stops growing as quickly, there are typically minimal decreases in demand at consumer-oriented companies, particularly those that produce staple goods that people need regardless of economic circumstances.
As a result, these defensive stocks' valuations have climbed dramatically. When you look at the stocks with the highest earnings multiples in the Dow, you'll find several consumer stocks among the most expensive.
Some of those stocks seem justified, given their recent performance. Nike (NYSE:NKE) announced its earnings last week, and its growth even in the face of poor conditions internationally arguably justifies its rich earnings multiple. Similarly, Home Depot (NYSE:HD) has repeatedly found ways to take advantage of favorable conditions in the housing market, appealing to do-it-yourself homeowners and professional contractors alike in building up its business. Even Disney (NYSE:DIS) seems to trade at a reasonable valuation given the huge growth potential of its multimedia empire.
Yet other consumer stocks have hit lofty levels despite facing growth challenges. Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD), and Procter & Gamble (NYSE:PG) all have extensive foreign exposure that leaves them open to currency risk; while their dividends have remained stable and attractive, their overall growth rates have left something to be desired. Yet all three trade at more than 20 times trailing earnings -- levels that would ordinarily be reserved for stocks with better growth prospects.
At the other end of the spectrum, financial stocks occupy the Dow's bargain basement, with Travelers (NYSE:TRV), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM) all sporting low earnings multiples on both a trailing and forward basis. Investors have some cause to be nervous about financials, as the threat of regulation looms large over the two Wall Street investment banks, while Travelers has enjoyed almost unprecedented good luck in avoiding large catastrophe losses in recent years after a bad stretch of hurricane activity earlier in this decade. The latest results from the Federal Reserve's stress tests showed continued concerns about the investment banking industry, as both Goldman and JPMorgan had to resubmit their capital proposals to gain approval. Still, if the economy keeps moving forward, financials have every chance of participating in overall economic growth, lifting shares and providing a potential for expanding valuations.
Value investors need to go beyond their past ideas of where to look for good stocks and seek out other corners of the market. Otherwise, they could end up buying their favorite stocks at too-rich valuations -- and suffer the consequences in the next market downturn.