Deep Dive: The best-performing sector of the S&P 500 is still the cheapest, while technology stocks look overvalued

The following tables present data for the 11 sectors of the S&P 500 SPX, +1.13%. Several tables will be used to show the pattern of forward price-to-earnings valuation changes and projections for sales and earnings through 2024.

Any company’s forward P/E ratio may not be very meaningful by itself. For example, Amazon.com Inc. AMZN, +2.10% has been trading at high P/E multiples for decades, but these haven’t stopped the stock from performing well as its rapid revenue growth has continued. At the close on March 18, Amazon traded for 59.8 times the consensus earnings-per-share estimate for the next 12 months among analysts polled by FactSet, while the S&P 500 traded at a weighted forward P/E ratio of 19.4.

All price changes discussed in this article are through March 18.

Current valuations and five-year averages

Here’s a comparison of current forward P/E ratios for sectors of the S&P 500, in alphabetical order, with the index’s valuations at the bottom. The current valuations are also compared to the index’s valuation and to their own five-year averages:

Some observations of the data in the first table:

• Only the communications services and materials sectors trade at forward P/E ratios that are below their five-year averages. It is important to note that the communications services sector went through a major transformation in 2018, with the addition of several large tech-oriented companies, including Facebook (now Meta Platforms Inc. FB, +2.44% ), Netflix Inc. NFLX, +2.22% and Google holding company Alphabet Inc. GOOG, +2.78% GOOGL, +2.77%. Meta’s stock has fallen 36% this year, while Netflix has dropped 45%.
• Despite the energy sector’s 32% gain this year, the sector trades for only 60% of the S&P 500’s valuation. It trades above its five-year average valuation to the S&P 500 of 40%, but for much of that time, oil prices were relatively low, or even shockingly low, as they were when forward-month contracts for West Texas Crude Oil CL.1, -0.73% briefly fell below zero in April 2020 after demand collapsed during the early periods of the coronavirus pandemic.
• The information technology sector is down 10.9% this year, but it still trades higher to the S&P 500 that it has on average over the past five years.
• The materials sector is the third-cheapest relative to the current forward P/E of the S&P 500, and it is trading below its average five-year valuation relative to the index. You might be surprised that despite all the reports of supply shortages and potential difficulties springing from Russia’s invasion of Ukraine, this sector has fallen 5.4% this year.

Sales and earnings projections

Next, let’s look ahead at expected compound annual growth rates (CAGR) for revenue and earnings from 2022 through 2024. Looking past the 2021 numbers, which for some industries and sectors were still grossly affected by pandemic-related stimulus, and setting a baseline for 2022, might provide useful indicators for long-term investors.

First, here are weighted consensus sales per share estimates for the sectors from calendar 2022 through 2024, with projected two-year CAGR:

• The consumer discretionary sector, which includes Amazon, is expected to show the highest sales-per-share CAGR through 2024. This is also the most expensive sector relative to the full index, which is typical, as you can see in the first table.
• The energy and materials sectors are expected to show slight declines in sales for the two years following 2022.

Now let’s look at earnings-per-share estimates and CAGR projections:

• The EPS estimates factor in expected reductions in share counts from stock buybacks. You can see double-digit CAGR expected for the communications services, consumer discretionary, financial and industrial sectors. Of these, only the communications sector and the financials trade at current discounts to the S&P 500.
• The current forward P/E valuation of 73% of the full index’s valuation for the financial sector is typical. This sector is trading at a forward P/E that is higher than its five-year average.
• The communications sector is trading at a discount to its five-year average.
• The slight declines in EPS expected for the energy and materials sectors are in-line with these sectors’ expected sales declines.

Energy ETFs worth researching

Investors looking for a bargain still appear to have one in the energy sector. A combination of low capital spending among U.S. oil and gas producers, combined with rising demand and the global supply disruption, all bode well for price support and cash flow.

You can read more about the capital spending and cash-flow prospects for the oil and gas industry here.

One way to invest in large domestic energy producers as a group is the  Energy Select Sector SPDR ETF XLE, -0.63%, which holds all components of the S&P 500 energy sector. Another is the iShares Global Energy ETF IXC, -0.39%, which holds all the stocks in XLE, but adds large players based outside the U.S., such as TotalEnergies SE TTE, +1.92% TTE, +0.89% and BP PLC BP, -0.99% BP, -0.44%.

For investors looking for long-term growth, the communications sector’s discount and expected EPS CAGR may be appealing, but this group is varied, and you should carefully consider evolving business models and long-term prospects.

For the information technology sector, it would appear that some of the headlines in the financial media can be a bit misleading, because obvious tech-oriented names, such as Meta, Netflix and Alphabet, are actually in the communications sector. The tech sector itself remains expensive and its two-year projected sales and EPS CAGR are in the middle of the pack.

It is no surprise to see the highest expected sales and EPS CAGR rates for the consumer discretionary sector. Investors are expected to keep getting what they pay for, but the price is high.

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