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Hold That Button Before You Buy Consumer Staples for Safety (XLP)

Valuations are indicating that the upside is capped from here


Consumer staples stocks are generally thought of as being the “safe,” defensive area of the market, but once valuations reach a certain level, the sector becomes a higher-risk proposition.

This might be where we are right now.

Since the beginning of March, the Consumer Staples SPDR (XLP) has gained 10.9%, outpacing the 8% gain of the SPDR S&P 500 ETF (SPY) and all of the other major sectors with the exception of materials and energy.

So before you go blindly hunting the consumer staples field in search of defense and yield … well, read on.

Bonds, Dollar Are Two Key Positives

First things first: What’s driving the gains in consumer staples?

The obvious answer would be that the slowdown in growth is causing investors to look for safety and stocks with lower economic sensitivity. However, this notion is belied by the recent outperformance of the materials and energy sectors, which would be expected to underperform in a true flight to safety.

Instead, the unseen force guiding the consumer staples sector higher might well be the decline in Treasury yields.

XLP has demonstrated a higher correlation with the iShares 20+ Year Treasury Bond ETF (TLT) than SPY, in the past one-, three-, five- and 10-year periods. (Keep in mind, TLT tracks the price action of long-term Treasuries, meaning that it gains in price when Treasury yields fall).

With Treasury yields having plunged so far in 2014, consumer staples stocks have regained traction following their underperformance of 2013. The reasons for this are likely twofold:

  1. Consumer staples offer high dividends and are therefore yield-sensitive in the same way as utilities or REITs.
  2. Consumer staples, like bonds, offer a haven from slowing growth.

While bond-market action has been a positive factor so far this year, this trend might be about to run its course. It will take much more in the way of bad economic news to drive the 10-year yield from 2.5% to 2% than it did to fuel its move from 3% to 2.5%. And if that happens, all stocks — not just consumer staples — will feel the pain.

The downtrend in the U.S. dollar has also played a part. Since the beginning of February, the PowerShares DB US Dollar Index Bullish Fund (UUP) has declined 1.7%. This has been a substantial positive for companies — including many of those in the consumer staples sector — that earn a substantial portion of their revenues overseas.

However, with UUP nearing long-term support, this tailwind soon may dissipate. From a fundamental standpoint, the dollar could see support from the fact that central banks in Europe and Japan are maintaining loose monetary policies even as the U.S. Federal Reserve continues to taper quantitative easing.

Consumer staples stocks XLP

Dollar Index

Valuations Have Become Rich

The other key issue is valuation. In early February, I wrote about how the valuations in the consumer staples sector had finally dropped to attractive levels after having been very pricey through most of 2012-13. With investors having eased away from the dividend stocks theme of 2011, consumer staples gradually staged a valuation correction to move back in line with the market.

While that has helped performance in recent months, the sector is now back to being expensive.

According to FactSet’s May 9 Earnings Insights piece, consumer staples are currently the most richly valued sector in the market at 17.7 times forward earnings. At this level, the P/E stands well above its five-year average of 14.9 and its 10-year average of 15.9%. It’s also higher than the 15.2 P/E of the S&P 500, which is itself above its own 10-year average of 13.8.

Unfortunately, investors aren’t getting what they pay for in terms of growth.

FactSet reports that the sector is estimated to generated earning growth of just 5.0% in 2014, second-worst of the ten major sectors (only utilities is worse) and well below the 7.8% estimate for the S&P 500. The consumer staples sector also is lagging in terms of 2015 estimates, with earnings growth projected at 9.3% vs. 11.3% for the S&P 500.

Bottom Line

Together, these factors indicate that the sector’s upside capped from here. Investors now need to be selective, focusing on individual company stories that can generate outperformance without the benefit of broader sector tailwinds.

Consumer staples shares have had a good ride, but the going is likely to get tougher from here.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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