At the beginning of a bull market, it's often the most speculative stocks that perform the best. As the market has rebounded over the past year, the Dow Jones Industrial Average ($INDU) is up about 40% while the S&P SmallCap 600 Index is up about 58%. And that is exactly why Richard Moroney, editor of Dow Theory Forecasts, is now sounding warning bells.
"The risk trade has defied conventional wisdom by continuing this year, tempting some investors to throw out their playbook and join the rush into high risk stocks," says Moroney.
Moroney warns that investors chasing after risky companies will now be paying a premium for low quality merchandise. Instead, he suggests that investors pursue attractively valued stocks with good fundamentals.
Moroney points out that if you exclude stocks with price/earnings ratios above 75 or below 0, the median stock in the S&P SmallCap 600 Index has a trailing price/earnings ratio of nearly 20, an 11% premium to the norm since 1994.
By contrast, the median among the large stocks in the S&P 500 Index is 18, a 4% discount to the norm since 1994. The 50 biggest stocks in the S&P 500 now have a median P/E of less than 17 -- a 22% discount to the norm.
Look For Attractively Valued Large Caps
Another mistake that investors make is valuing cyclical stocks based on recession-depressed earnings. "Investors are paying an unusually high premium to bet on heavy cyclicals, especially when growth cyclicals in the technology and consumer sectors are available at modest valuations," says Moroney.
If you want exposure to economically sensitive stocks, Moroney says to look for attractively valued shares of companies with solid finances and good track records. Among his current recommendations are Lubrizol (LZ) and Oracle (ORCL).
Another piece of advice: Don't limit yourself to classic cyclicals. Even a health-care company like Varian Medical Systems (VAR) could see improved demand, says Moroney, as hospitals benefit from lower bad-debt expenses.
If the economy continues to exceed expectations, small stocks and low-quality cyclicals may continue to outperform in the near term. But today's valuations give Moroney a high degree of confidence that high-quality large stocks will outperform over the next several years.
Along these lines, Moroney's top picks right now include Aflac (AFL), CVS Caremark (CVS), and Stryker (SYK), all of which trade at sharp discounts to historical norms.
Reading a Stock Quote
Learn to read the ingredients of a stock.View Course »