Diagnosing Healthcare Stock Headaches

Healthcare companies now make up more than 12% of the S&P 500 Index, but they account for 25% of the stocks that earned the lowest possible score from my IDEAL Stock Rating System.

Only the bloated ‘financials’ sector earns a lower average IDEAL score than healthcare stocks, but those stocks have been on a tear lately so it’s no surprise they look rich at the moment.

That implies the entire healthcare sector is overvalued, even though many of these stocks have not fully participated in the post-election rally that has pushed the stock market to record highs. In fact, the Health Care Select SPDR ETF (XLV) has declined nearly 3% since peaking on Nov. 10, after jumping 8% during the preceding week. That means the net gain in this sector since the election is not only less than that of the current bull market for stocks, but the trend is going in the opposite direction.

The reason is the relief rally triggered by Hillary Clinton not being in a position to ensure that the Affordable Care Act (ACA) remains intact, which was quickly followed by apprehension over comments from President-elect Trump that he may keep parts of the ACA (contrary to his campaign promise to abolish it). At this point nobody is sure what will happen with the ACA next year, and healthcare stocks are paying the price for that uncertainty.

Of course, where there is uncertainty there is also opportunity. Odds are several healthcare stocks are mispriced now and will be more volatile than the overall stock market in the months to come as Trump makes clear his true intentions. The companies that end up on the right side of changes to the ACA should see big gains, while those on the wrong side will likely continue to lose value.

If you want to make a bet on the entire sector going up then you can use the ETF referenced above, but if we get an equal number of winners and losers then that may tread water. However, a quick look at the entire healthcare sector as scored by my IDEAL scoring system (scale of 0 to 10, higher is better) reveals that there is one company that earns a nearly perfect score of 9, and another with a score of 8. Seven other healthcare stocks get a score of 7, resulting in nine companies that are likely to outperform their sector peer group over the next twelve months. (I’ll be reviewing the top scorers in a January issue of Personal Finance.)

I don’t know how the ACA situation will play out next year—I doubt anyone does at this point. For all we know Trump might end up ignoring it altogether, choosing to focus his energy on infrastructure spending and tax reform. Or he may make it his first target.

But I do know that the stock market has a nasty habit of enforcing “reversion to the mean” when investors least expect it, turning today’s high-flying momentum stocks into tomorrow’s dogs.  The good news is the opposite is also true: undervalued stocks eventually rebound, generating exceptional returns to their shareholders in the process. If you know which ones those are, you can make a lot of money next year while other investors figure it out the hard way.