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Is the Market Overvalued? A Look at the Consumer Discretionary Sector

With the TSX showing an impressive one-year return of 18% a five-year return of 26% and trading at all-time highs, investors should be feeling nervous. Are valuations getting ahead of themselves or is there room to go higher?

I prefer to answer this question by looking into the different segments of the market and making a case-by-case conclusion, and hopefully finding the areas with the most value. Let’s look at the consumer discretionary sector and delve a little deeper.

The consumer discretionary sector has a one-year return of 16% and a five-year return of 110%. The interest rate environment has been conducive to consumer spending, and consumers have gone all out to take advantage of this.

We certainly have to compare these returns against economic fundamentals and market valuations to formulate an opinion on whether the market is overvalued or not. From a macroeconomic perspective, the consumer discretionary sector is standing on thin ice and has been for a while now.

Household debt continues to rise. According to Statistics Canada, household debt to disposable income now stands at 168.95, and debt to GDP is 101.15 — well into unsustainable territory. And while interest rates are still low, they are on their way up in the U.S. Although Canada may have a period where it will benefit from a weak Canadian dollar as rates in the U.S. rise faster than in Canada, longer term, rising rates will spell hard times for the consumer.

Valuations in the sector vary, but all in all, they look high. It pains me to say it because these companies are very well run, but companies like Cineplex Inc. (TSX:CGX) and Dollarama Inc. (TSX:DOL) are trading at rich valuations and on high expectations, so if and when something goes wrong, they have far to fall.

While Cineplex is pretty much flat versus last year, the stock has a five-year return of 84% and it trades at a P/E multiple of 40 times 2016 earnings and 29 times 2017 consensus earnings. And while in the long term, I still really like this stock, I believe that in the short term, the risk/reward relationship has shifted, just as it has for many stocks in the market due to the fact that they have rallied so high in recent years.

Dollarama Inc. is flat versus last year but up almost 400% in the last five years. The stock trades at a P/E of 34 times 2016 earnings and 28 times 2017 expected earnings. While shoppers would probably opt to shop at Dollarama in favour of other retailers in difficult times, it does not change the fact that these valuations are high, especially given that interest rates are on the rise and household debt has risen to unsustainable levels.

No matter how high quality these companies are, there is a point where investors begin to overpay for their shares, and it seems that this is happening at this time.

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Fool contributor Karen Thomas has no position in any stocks mentioned.

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