The mania for stable, dividend-paying stocks might no longer make daily headlines, but that doesn’t mean that the defensive sectors have become more attractive.
In fact, the consumer staples, utilities and healthcare sectors remain richly valued in relation to their historical average despite their below-average earnings potential. Therefore, investors — especially those in search of lower-beta investments or so-called “bond proxies” — must approach these sectors with caution.
Defensive Stocks Aren’t Actually ‘Safe’ Right Now
The table below, which is based on data calculated and published by FactSet, shows how each sector’s current valuation premium or discount to the broader market compares to the five- and 10-year averages. For instance, health care stocks are currently trading at a 9.5% valuation premium to the broader market, which is a full 8.1 percentage points above the 10-year average of 1.4%. Utilities, at 5.5 percentage points above its 10-year average, and staples, at 2.8, are second and third in terms of the gap over their longer-term norm.
Notably, all three of these sectors are on track for earnings growth below that of the broader market in the year ahead — meaning investors aren’t getting what they’re paying for.
|10-yr AVG. P/E||+/- S&P 10-Yr Avg. P/E||5-yr AVG. P/E||+/- S&P 5-YR AVG P/E||Current P/E||+/- S&P P/E||2014 Earnings Est.|
One argument why premium valuations are justified for these groups is that they pay above-average dividends. In reality, however, the dividend advantage isn’t that significant.
For example, the Health Care SPDR (XLV) currently offers a yield of just 1.52%, below the 1.82% investors could earn on the SPDR S&P 500 ETF (SPY). The Consumer Staples SPDR (XLP), at 2.33%, provides a modest advantage, while only the Utilities SPDR (XLU), at 3.79%, yields appreciably more than the index.
Still, it’s important to keep in mind that this yield gap — at 2 percentage points — would be more than offset by the impact of the sector’s valuation reverting closer to its historical discount from its current premium.
The primary catalyst to bring the valuations of these three sectors back in line with their 10-year norms would be weakness in the bond market. Just look at the bond selloff from this past spring. From May 2 through June 25, the yield on the 10-year Treasury note soared from 1.63% to 2.59%. SPY returned -0.21 during this time frame, but XLU and XLP greatly lagged with returns of -8.79% and 3.58%, respectively. XLV held in somewhat better by breaking even, but this result represents a departure from the healthcare sector’s otherwise strong relative performance of the past year.
The takeaway: “Defensive” doesn’t necessarily mean “safe.”
Of course, this table doesn’t just outline the rich valuations of defensive stocks. Investors also can glean four additional nuggets from the valuation data above:
- Valuations can’t be looked at in a vacuum. The energy sector is a prime example: The sector P/E is currently 13.6% below that of the S&P, which on the surface might indicate an opportunity. But looked at in the context of history, we can see that such a discount is typical for the group — undoubtedly due to the drag created by mega-caps such as Exxon Mobil (XOM). This type of perspective can help prevent investors from reading too much into what seems like “bargain” prices in a particular group.
- Tech is cheap for a reason. Technology stocks have experienced massive valuation compression in recent years, as evidenced by the huge gap between the sector’s current P/E and the 10-year average. Still, a look at the earnings column tells the full story: Tech, as a group, is on track for below-average earnings growth in the year ahead, indicating that the discount makes perfect sense.
- Consumer stocks are expensive for a reason. On the other side of the equation, consumer discretionary shares might not be as expensive as they appear at first glance. While the group trades at a large premium to the broader market, this is nothing new — and in fact it might be well-justified by earnings expectations that are nearly 50% above the S&P 500 as a whole.
- More good vibes for banks? Finally, financials could have some room for additional outperformance even though the Financials SPDR (XLF) has generated a gain of 37% in the past year, well above the 32.3% gain for SPY. Despite this outsized gain, the sector offers both a larger-than-normal P/E discount and the potential for market-beating earnings in the year ahead. It also should be noted that financials are the one sector that can actually benefit if rates begin to tick higher.
Valuation isn’t everything, and it certainly isn’t a catalyst for performance. Nevertheless, this data set provides some perspective on the current state of the market and, perhaps most important, the potential danger in the “defensive” segments if the current bull run is derailed.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.