When your teenager starts to drive, you pay a higher insurance premium to guard against heightened risk. In a slow growth, “tweet prone” world, investors should expect to pay a premium for the safety of less cyclical names. That said, current valuations on many classic “defensive” stocks appear to be too high.
In April I suggested that even with modest growth, cyclical companies were looking attractive relative to more defensive names; the call was half right. Cyclical sectors such as technology, financials and consumer discretionary have all outperformed. What I got wrong was that defensive sectors were vulnerable to a correction at that time. Since mid-April U.S. utilities are up 5%, while consumer staples are up better than 6.5%.
Part of the explanation lies with interest rates. During the past 3-months U.S. 10-year Treasury yields have fallen to 2-year lows and much of the European sovereign debt market is back to paying a negative yield. As defensive stocks tend to be more sensitive to interest rates, they have rallied as interest rates have plunged.
Valuations and Rates Matter
Despite lower rates, the rally in defensives may have gone too far. Unless you believe we’re facing a recession or that interest rates will go lower and approach the 2016 lows, many defensive stocks in the U.S. look expensive based on absolute valuations, relative valuations and compared to the interest rate environment.
Starting with absolute valuations, the S&P 500 Utility Sector is currently trading at nearly 20.5x trailing earnings, a post-crisis high. Staples are even more expensive at 21x trailing earnings, although this appears more reasonable relative to the sector’s own history.
Valuations also look extended relative to the S&P 500 Index. Utilities are trading at a 4% premium to the broader U.S. stock market, staples 7% above. Both are above the post-crisis average, with utilities looking particularly extended (see Chart 1).
Finally, as discussed in April both sectors look stretched compared to interest rates. This is important. In the post–crisis world both sectors have often traded more in-line with interest rates than the stock market. Based on the post-crisis relationship, utility stocks look particularly vulnerable.
A simple model of relative valuation vs. rates suggests that the utilities sector should be trading at a 5% discount to the market, not a 4% premium. Put differently: You would need to expect long-term rates in the U.S. to fall to the June 2016 low, around 1.35% for the 10-year U.S. Treasury note, for utility stocks to be trading near fair-value.
As I’ve often pointed out, valuation is a poor market timing tool. Should trade frictions escalate or some other exogenous shock knock the U.S. into a recession, both utilities and staples would likely outperform. That said, if you assume that economic growth will remain low but still positive, investors appear to be putting too high of a premium on safety. While defensive stocks play a role in a portfolio, absent the economy falling off a cliff, a little trimming may be in order.