Thursday, May 30, 2013

"Safe" Stocks Have Become Dangerous

Although the market has rocketed almost +17% higher so far this year, the leading sectors has been those areas that are normally considered "defensive".

Health care (+25% YTD); Consumer Discretionary (+20%) and Consumer Staples (+17%) have led the market for the first five months of 2013, while Technology (+10%) has brought up the rear.

This year's market action reflects the continued skepticism about stocks that pervades the thinking of most investors.  Many investors are buying stocks for their dividend yields and presumed relative safety, and ignoring underlying fundamentals.

This has driven valuations on many slow-growth companies to levels not seen for many years. On the other hand, faster growing companies that offer meager payouts are being shunned as too risky, despite being priced very modestly relative to their earnings growth.

Global equity strategist Savita Subramanian of Merrill Lynch put out a piece this morning noting how stretched the price/earnings multiples have become in several sectors (I have added the emphasis):

Low beta, high yielding stocks are trading at near record valuations to their higher beta, lower yielding counterparts.  Utilities has been trading at the highest relative forward P/E that we have seen in at least two and a half decades....low beta stocks have been trading near a 10% premium to the market, and have eclipsed high beta stocks's valuations for the last 11 months, the longest stretch we have seen in the history of our data (from December, 1986).

In other words, investors favoring a conservative style have been able to "have their cake and eat it too"; they have enjoyed high dividend yields and good relative performance from a group of stocks that historically would lag the market that has rallied so strongly.

So what happens from here?

Here's what Savita thinks:

Another common misconception by investors is that the highest dividend yield stocks will offer the best hedge against losing money, because even in a down market, one can clip the coupon - and the higher the coupon, the better the downside protection. We have repeatedly pointed out to investors the "Quintile 2" phenomenon - that the second tranche of stocks by dividend yield actually offer far more attractive risk to reward characteristics than the highest yielding stocks.  Stocks that pay the highest dividend generally have higher payout ratios and lower growth, and those are less likely to grow dividends.  And many stocks migrate into high dividend yield territory from falling prices, and these stocks actually are more likely to cut their dividends than to retain or grow dividends.

Savita's work indicates that this year's unusual market action has created numerous buying opportunities in areas like financials, industrials and technology.

On the other hand, she would be looking to move out of telecommications stocks, as well as REITs, where the risk/reward seems unfavorably skewed.