Bank of America has identified a major discount in the stock market that's about to get even more enticing
- The sell-off in stocks has cheapened the market.
- Ahead of the all-important earnings season, quant strategists at Bank of America Merrill Lynch say one sector on the S&P 500 outranks every other in their model.
Here's one benefit of the stock market's decline this year: it's cheaper to buy.
And according to quant strategists at Bank of America Merrill Lynch, no sector looks better than technology.The S&P 500 Information Technology sector has declined by more than 5% since January 21, when the stock market peaked, although it's still green for the year. The drop has been due to concerns ranging from data privacy at Facebook to the safety of self-driving technology to America's trade disputes with China. Also, investors took a breather after tech stocks led the market during its meteoric rise last year and early in January.
The sell-off has reduced tech's forward price-to-earnings ratio, a valuation gauge that compares stock-price changes to estimated earnings; if prices fall by more than changes in earnings forecasts, the ratio decreases.
"P/Es for Financials, Materials, and Tech (March's worst-performing sectors) compressed most last month," Savita Subramanian, BAML's head of US equity and quant strategy, said in a note on Friday.
"Tech now trades at a 6% discount to its long-term average (ex-tech bubble) relative P/E, and is back to ranking #1 in our quant model given its strong three-month momentum (best-performing sector in 1Q despite its sell-off), healthy revisions and historically inexpensive relative valuation. It also screens as one of the top three sectors to own this earnings season."
If this year's market moves are making investors feel uneasy, it might be because they had it really good last year, when volatility was at historic lows.
What we're witnessing now is closer to the norm. Subramanian noted, for example, that the tech sector experienced at least two drops of 10% or more every year from 1995 through the peak of the tech bubble in 2000. In 1999, near the height of the bubble, there were four such corrections that created buying opportunities.And in a few months, tech valuations could get even better.
In September, S&P Dow Jones Indices will broaden the Telecommunication Services sector to include some media and tech stocks, creating a new sector called Communication Services. The index provider said it's doing this because many of these companies have evolved to offer very similar services. For example, Verizon provides media and entertainment content through its recently created subsidiary Oath, in addition to cellphone service.
Based on current valuations, Subramanian estimates that the forward price-to-earnings ratio of tech would drop by one point as some expensive stocks leave the sector. Also, consumer discretionary's forward P/E would rise by a point as the media group, one of its cheapest, moves to a different sector.
Here's a chart showing what BAML estimates that would look like: