Betting on Sector ETFs in a Highly-Valued Market

By Max Isaacman, Contributing Writer

As one who sold stocks to investors in the early 1970s, I realize how misleading price/earnings multiples (P/E) can be. Although these multiples have their limitations, P/Es can be useful when making valuations. Still, other valuations should be used in conjunction with P/Es to paint a broader picture.

Even with the current high P/Es and taking other valuations into account, exchange-traded funds (ETFs) should be bought with long-term appreciation in mind. This article will focus specifically on the Standard & Poor's (S&P) 500 (SPY), the S&P MidCap 400 (MDY), and some of the sector SPDRs.

As far as size, S&P considers companies valued at $5.0 billion and larger to be large-cap companies, and therefore suitable for SPY. Small-cap companies are those valued at $1.0 billion and smaller. Mid-cap companies are classified as those somewhere in between.

Of the sector SPDRs, I find the Energy Sector SPDR (XLE), the Financial Sector SPDR (XLF), and, for patient value-oriented investors, the Basic Industries Sector (XLB) to be particularly useful.

Selecting an index that represents the stock market

The S&P 500 provides a broad representation of the stock market. The roots of this index started back in 1928, but the index as we know it today was developed in the late 1950s. At the time it was formulated it was designed to be an all-encompassing benchmark, reflecting the U.S. equities market. The index includes more than 100 industries in 11 economic sectors. The strategists at Standard & Poor's constantly revise the S&P 500 so that it continues to be an accurate representation of the stock market.

When an old-economy company in the index is to be replaced, strategists at S&P do not replace it with a new-economy stock because they think that a hot technology stock has more appreciation potential. S&P is not about guessing which sectors or industries will appreciate the most. There are restrictions on the stocks that S&P can use, and how often changes can be made. This keeps the indexes from becoming too aggressive.

MDY and SPY are a reflection on the domestic markets, and include only companies that are U.S.-based. Also, the companies are required to have sufficient float, so that the funds based on these indexes can invest in the company. To be a part of the index, the company must also experience positive earnings or cash flow. Also, not more than 50 % of the shares of the selected companies can be held by management or insiders. Naturally, these criteria exclude many dot-com companies in the technology sector.

Is the S&P 500 realistically priced?

Some analysts believe SPY is selling at too high a valuation. SPY currently sells at about 25 times forward earnings. This is historically a high P/E, escpecially when considering that for most of the past 25 years the index has had a multiple somewhere in the teens. But this valuation can be justified by changes the index has experienced. One should keep in mind that the multiple is not the only gauge to measure an index's value.

Many analysts today use a P/E to Growth Ratio (PEG). Using this ratio allows one to measure a company's P/E more in line with its growth rate. The mathematical expression of this ratio is given as a variation from 1.0; 1.0 is considered a "fair" value. The lower the number from 1.0, the greater the discount from fair value. As an example of this calculation, suppose that a stock sells at 10 times earnings, and has a 10% earnings per share growth rate - its PEG ratio is 1.0. A stock at 20 times earnings with a 10% earnings growth rate has a 2.0 PEG, twice its fair value.

According to Sam Stovall at S&P, the SPY PEG ratio, calculated to the ETF's projected five-year growth rate, is 1.4 times. This figure does not seem as high in light of SPY's growth bias.

SPY - active growth fund?

Over the last 36 years, 740 companies have dropped out of the SPY. This is a rate of about 20 companies per year, or roughly 1.5 companies per month. That's a high frequency of change in a portfolio - bordering on active account management.

In a recent report, Douglas Cote at Aeltus Investment Management points out that the trend toward the number of company changes in SPY has accelerated. Cote reports that there were 89 portfolio changes in 1999, and 59 changes from January 1, 2000 through July 27, 2000 - a sharp increase indeed.

                                                                                       Next >>

Printer Friendly Page E-Mail to a Friend