The S&P 500 is having a great year. The leading index is up 13% in the first three quarters of 2017. At this rate it's is on pace to finish with an 18% total return in 2017.
By almost every measure this is great news for investors. However, in one way it creates a dilemma. U.S. stocks looks expensive right now compared to historical averages and international counterparts.
The S&P 500’s P/E ratio of 25 is at the higher end of its long-term range. Take a look below.
This P/E ratio is also a sharp premium to its international counterparts. For example, the iShares MSCI Emerging Markets (NYSE: EEM), which broadly tracks emerging market equities, has a forward P/E ratio of 13. The Vanguard Total World Stock Index (NYSE: VT) has a forward P/E ratio of 17.5.
This relatively high valuation is making a lot of investors nervous. Not only can it be intimidating for investors to buy stocks trading at an all-time high, but an overbought market makes it difficult to find value stocks.
According to historical data, this has important implications for potential returns. A recent study by Bank of America Merrill Lynch shows that value stocks have a history of delivering outsized returns.
The study tracked the performance of value stocks and growth stocks over a 90-year period from 1926 to 2016. Over that time growth stocks generated an average annual return of 12.6%, while value stocks delivered an average annual return of 17.0%. The study also found that value also outperformed growth in three out of every five years.
If you’re a value investor, don’t despair. I have a secret that many investors are missing right now.
While the overall S&P 500 looks overvalued, there are a few hidden sectors that are actually on sale. For example the Financial Select Sector ETF (NYSE: XLF) has a forward PE ratio of 16, a 20% discount to the S&P 500.
Within these undervalued sectors are even more undervalued stocks -- global leaders trading at huge discounts to the broader market. If you’re looking for the best and most undervalued U.S. stocks, my list below is a good place to start.
The Seven Most Undervalued S&P 500 Stocks
|Name||Ticker||Forward PE Ratio|
|Walgreens Boots Alliance||WBA||14|
These are some of the most powerful and recognized brands in the world. And despite the S&P 500’s high P/E ratio, these companies are on sale. According to history, that increases the probability they will deliver outsized returns.
From this list I have chosen to highlight Apple and JPMorgan Chase because of their unique combination of value and growth.
Apple (Nasdaq: AAPL) is on pace to become the first trillion-dollar company. Despite this potential landmark, it’s one of the most undervalued stocks in the entire S&P 500. Its forward P/E ratio of 14 is a 30% discount to the S&P 500’s 20. Despite the great value, Apple is set to post major revenue and earnings growth in the next two years. Earnings are on pace to grow 8% in 2017 and another 22% in 2018.
Apple is also transforming into dividend powerhouse. Although its dividend yield of 1.6% is less than the S&P 500’s 2.0%, Apple has raised its dividend by 209% in the last five years. Looking forward, with the largest cash balance in the world, I expect Apple to invest tens of billions into future dividend payments.
JPMorgan Chase (NYSE: JPM) is one of the most undervalued stocks in the undervalued financial services sector. JPM’s forward P/E ratio of 13 is a 35% discount to the S&P 500’s 20. Despite that huge discount, JPM offers a compelling combination of growth and income. Its current yield of 2.0% is in line with the S&P 500. And on the growth side JPM is on pace to grow earnings by 10% in 2017 and another 13% in 2018.
Risks To Consider: A low P/E ratio can sometimes be a sign of distress. I don’t think that is happening with my list of undervalued stocks, but it’s always important to figure out why a company’s share price is undervalued.
Action To Take: Value stocks have a proven history of outperforming the broader U.S. stock market and growth stocks. Even though the S&P 500 is trading with a historically high P/E ratio there are still dozens of stocks that are on sale. My list is a good place to start looking. From that list, Apple and JPMorgan offer the best combination of value and growth.
Editor's Note: A few months ago, a group of millionaires and billionaires gathered in a private conference room 26 miles from Mar-a-Lago to discuss their "Trump Era" investments. And believe it or not, a common theme was to invest in American businesses. 7 companies in particular stood out... Full story here.