As U.S. Overheats, Seek Out Energy Sector, Emerging Markets

Emerging markets and select U.S. stocks with good valuations should be a key part of a risk-averse portfolio, particularly now when the U.S. stock market is greatly overvalued, says J. Michael Martin, chief investment officer of Columbia, Md.-based Financial Advantage, Inc., a fee-only investment advisor.

Martin points to three key indicators as evidence of the U.S. stock market’s current frothy conditions:

The P/E-10 Ratio. This formula, developed by Yale professor Robert Shiller, uses a customized trailing 10-year average inflation-adjusted figure for earnings. The P/E-10 Ratio stands at 22.7, which is 39% above its historical average. “Except for the 1929 euphoria and the 2000 tech bubble, this number is about as high as it has ever been,” he says.

Tobin’s Q. This reading, created by Nobel Laureate James Tobin, measures the value of nonfinancial stocks by comparing market price to the replacement value of the companies’ assets. Tobn’s Q recently stood at 112, a peak it exceeded only during the dot-com bubble. The reading is 37% above its long-term average, Martin notes. “This indicator has consistently topped out and headed south when it reached 106 to 108,” he says.

Dividend Yield. Divide a stock’s annual dividend per share by its price per share and you’ll come up with the dividend yield. For example, a company with an annual dividend of $1 a share and a share price of $20 has a dividend yield of 5%. In 2010, the dividend yield for the S&P 500 index stood at an unusually low 1.84%.

Underweight U.S. Equities and Focus on Value

What are the lessons? Two energy stocks Martin likes are Apache Corp. (APA) and Enerplus Corp. (ERF), which both stand to profit from increasing demand for oil and gas spurred by booming emerging nations.

“We’re still finding attractively priced businesses with solid competitive positions that are likely to prosper even in a sluggish economy,” he says.

Martin looks for companies with the ability to gain market share, a strong balance sheet, higher operating margins than competitors, and strong markets abroad. Besides energy and mining, some companies in the technology and retail industries that meet standard, he says.

Use Mutual Funds to Invest in Emerging Markets

In addition to value plays in the U.S. market, Martin recommends investors broaden their exposure to emerging markets. “There are good values in the emerging markets as they embrace modern technology and free-market concepts,” he says.

His fund picks include Templeton Global Bond (TGBAX), Aberdeen Emerging Markets (ABEMX) and Wasatch Emerging Markets Small Cap (WAEMX).

Financial Advantage, in Columbia, Md., provides personal financial planning and investment-management services to retirees and aspiring retirees on a fee-only basis, and provides portfolio management for other financial advisors. “Wealth Manager” magazine and “Financial Advisor” magazine have named Financial Advantage, with about $258 million under management, one of the top independent financial advisory firms in the country. Martin, CFP, was named one of the region’s top fee-only financial planners by The Washingtonian magazine.