The market just keeps on going. Both S&P and Nasdaq made yet another new high this week.
The market laughed off the threat of the historically treacherous September and increased the pace of ascent. The S&P is up 3.3% for the month so far. It’s also up over 13% YTD and 37% from the April low.
Why not? We’re in a Fed rate-cutting cycle. The AI catalyst is going strong.
And the economy is nowhere near recession. There are reasons to be optimistic. And the optimists have been right about the market for a long time.
But there’s a problem. Stocks are expensive. A common gauge of stock valuation measures stock prices relative to earnings, the price/earnings ratio. The S&P 500 PE ratio is now over 30. The historical average is around 15 or 16. In fact, the market PE has been this high only one time in the past 100 years. That was during the dot.com bubble before the crash.
S&P 500 PE Ratio
Technically, the market PE rose higher during the pandemic and the financial crisis. But the numbers were skewed because corporate earnings fell off a cliff. Those aberrations aside, the market has only been this expensive one time in history. And things didn’t go well.
Of course, there are some justifications for the high PE ratio. Artificial intelligence is providing the biggest earnings growth catalyst in a generation. And technology stocks now comprise a third of the S&P 500 index, a much higher percentage than ever before.
[text_ad]
Information Technology has been by far the best performing of the 11 S&P 500 stock sectors for a long time. The sector returned 176% over the last five years, compared to a 101% return for the S&P over the same period, which was only up that much because of technology. The tech sector returned a staggering 732% over the last ten years, nearly three times the return of the overall market.
The price appreciation in already large technology companies has been unprecedented. Broadcom (AVGO) is up 659% over the last three years. Nvidia (NVDA) is up 1,331% over the same period. Oracle (ORCL) has doubled in price since May. But unlike the dot.com era, it’s not just smoke and mirrors. The stocks rose because of soaring revenues. Sure, the stock price can’t be justified based on this year’s earnings. But the anticipated earnings over the next five or ten years do justify the current high prices. One could certainly argue that the historically high market PE is a natural consequence of the unprecedented earnings growth from AI. But still, things have to go very well in the future to justify these prices. Maybe they will. But it’s tempting fate to price in perfection. I’ve lived a long time. My experience is that something always goes wrong eventually.
The market is high. Even the greatest bull markets selloff periodically. And a selloff seems overdue. It’s a good time to tone down expectations and focus on the part of the market that isn’t too expensive. There are some great buys out there that can provide solid returns away from the rollercoaster.
The current situation calls for a certain kind of stock that can thrive in almost any market environment. If the market takes off, it can participate. If the market goes flat, it can generate positive returns. And if the market turns south, it can yield superior relative returns.
A good choice in this environment is midstream energy. These companies don’t rely on volatile commodity prices, but rather generate fees from the transport, storing, and processing of oil and gas. Demand should be resilient, especially for natural gas, and the high dividends provide a great buffer.
Historically, the better midstream energy stocks have provided a high income and a solid return throughout most market cycles. And that makes them ideal for the current unpredictable environment. But that was before. Things are changing. The environment for energy is undergoing a radical transformation that could make these stocks better than ever before.
Demand for natural gas is soaring in the U.S. and overseas. The demand is being driven by electricity. Natural gas is by far the number one source of electricity generation. After being stagnant for decades, electricity demand growth is skyrocketing because of massive trends in artificial intelligence, electric vehicles, and an onshoring boom in manufacturing. Natural gas exports are also poised to rocket higher in the years ahead.
The current environment provides a huge runway for earnings growth that the historical stock performance doesn’t reflect.
Enterprise Product Partners L.P. (EPD)
Yield: 6.9%
Years of Consecutive Dividend Increases: 27
Enterprise Product Partners is one of the largest midstream energy companies and Master Limited Partnerships in the country, with a vast portfolio of service assets connected to the heart of American Energy Production. It is connected to every major U.S. shale basin and 90% of American refiners east of the Rockies and offers export facilities in the Gulf of America.
Current assets include the following:
- 50,000 miles of pipeline
- 300 mmBbls of liquids storage
- 21 deepwater docks
- 45 natural gas processing trains
- 26 fractionators
As a midstream energy partnership, Enterprise is not reliant on volatile commodity prices because it generates about 80% of revenue from fees for storing, processing, and transporting oil and gas. They collect tolls on the U.S. energy highway at a time when production is likely to increase substantially.
The first thing that probably comes to mind when considering EPD is the distribution. EPD currently pays a $2.18 annual dividend, which translates to a 6.9% yield at the current price. Is that massive yield safe?
As an MLP, Enterprise pays no income tax at the corporate level and pays out the bulk of earnings in the form of distributions. The payout ratio has been in the 65% to 80% range over the past few years, which is lower than most MLPs and enables the partnership to invest its own capital in growth projects at lower cost.
EPD has performed very well over the last several years. Over the past three calendar years (2022, 2023, and 2024), EPD returned 78% with distributions reinvested compared to a return of just 28% for the S&P 500 over the same period. The MLP provided triple the market returns with just a fraction of the volatility. Yet, despite the recent success, EPD still sells well below the 2014 high with much higher earnings and a PE ratio of less than 12 times. It also has a beta of just .66, meaning it is a third less volatile than the overall market.
Enterprise is on the cusp of an earnings growth spurt. The partnership will have $6 billion in expansion projects coming online in the second half of this year. The new capacity should significantly expand cash flow and earnings in the next two quarters and well beyond.
Not only is Enterprise on the cusp of a huge pick-up in earnings growth, it’s also dirt cheap in an expensive market. EPD sells at a PE ratio of less than 12. The distributions will continue to flow in any kind of market. And the price has also proven resilient among inflation, rising interest rates, and a slowing economy.
[author_ad]
