Skip to main content

A woman holds a tablet displaying WhatsApp’s logo in front of the screen with the Facebook logo in this photo illustration taken in Prague Feb. 20, 2014.David W. Cerny/Reuters

If you're looking for something to blame for recent market volatility, you might start with highly priced U.S. tech stocks, consider evidence of a slowing Chinese economy and then investigate where the Donetsk People's Republic is located.

But the real culprit is likely far more obvious and considerably broader in scope: The stock market simply isn't looking too attractive right now.

Stocks took a drubbing on Friday, when the S&P 500 fell 24 points or nearly 1.3 per cent, for its biggest one-day retreat in two months. It was down another 5 points in early trading on Monday.

The overall damage is slight; the benchmark index has fallen just 1.6 per cent from its record high. But it's enough to raise questions.

For sure, tech stocks are leading the retreat. The tech-heavy Nasdaq composite index has fallen 6 per cent since early March. And the S&P 500 information technology index – which consists of companies such as Google Inc., Facebook Inc. and Adobe Systems Inc. – has fallen for four straight days, including Friday's sharp 2.2 per cent dip.

And yes, some of these tech stocks are expensive when you compare their share prices to their reported earnings.

But are tech stocks being used as a scapegoat for a broader market that also looks unappetizing?

Goldman Sachs strategist David Kostin pointed out on April 4 that profit margins are unlikely to rise much from their current record high levels. As well, the typical S&P 500 stock is trading at an estimated price-to-earnings ratio of 17.3, leaving little margin of safety if earnings expectations disappoint.

"Lack of attractive alternatives to owning stocks is the most persuasive argument for why S&P 500 will continue to rally," he said.

When the best reason for owning stocks is that assets like bonds and cash offer miserable returns, it's hard to work up much enthusiasm for anything. Indeed, Mr. Kostin remains cautious on stocks, with a 12-month target of 1,950 for the S&P 500, or 4.8 per cent above the current level.

However, he believes there are ways to navigate through a pricey market. First, he suggests that stocks with low valuations should outperform those with lofty growth expectations and high valuations if the U.S. economy grows at a 3 per cent clip. The idea here is that growth stocks – and that would include many of the tech stocks that are now swooning – don't look as special when the economy is doing well.

Second, a pickup in economic activity should reward stocks with a lot of operating leverage.

"The intuition is a slight pick-up in economic activity will lift sales and disproportionately benefit earnings compared with low or average operating leverage firms," he said in his note. "This strategy ultimately depends on positive earnings revisions rather than continued P/E expansion from already-high starting levels."

Examples include Bristol-Myers Squibb Co., EOG Resources Inc. and Autodesk Inc.

Third, keep an eye on companies returning cash to shareholders through buybacks. Examples include Pfizer Inc., Cisco Systems Inc. and Viacom Inc.