Are Investors Paying Too Big a Premium for Safety?

Following months of strong performance, Russ discusses why defensive sectors may be overpriced in the current environment.

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).