Groundhog's Shadow and the Cost of Fear: A Case for the Mounting Bubble in Defensive Stocks

Groundhog Day occurs in early February, and for a moment this spring, Investor Groundhog appeared from his defensive hole, saw no shadow, and ventured warily toward opportunity. After a cautious foray, the glare of possible recession and low rates made his shadow loom quite large and forced him back into his hole. There’s safety there (better yields than bonds, at least!). Plus, the European Union seems to be coming apart. Best to stay hidden. Come out next year, perhaps.

This is tongue-in-cheek, of course. Threatening storm clouds loom, and defense is of course vital for groundhogs and their portfolios. But the story captures the behavioral dynamics of the markets this year. In reality, investors have feared the shadow of slowing global growth for at least the past two years.

As always, this has created opportunity. It has also driven defensive investments into bubble territory, presenting higher-than-usual risk.

First, some numbers to illustrate our case:

 Chart: Defensive vs. Offensive Stocks Compared

For brief definitions of defense, offense, and “beta score”, see this footnote[1].

QUICK OBSERVATIONS

  • Historically, the average P/E multiple for both defensive and offensive stocks is around 17x-18x. Current multiples are at notable extremes.
  • Specifically, following Brexit (see our recent commentary here), the P/E’s for defensive stocks now trade higher than they ever have over the past 15 years. In comparison, the highs for offensive stocks were over 29x in 2003. This is an historic reversal and divergence. The spread between the P/E’s for defense and offense are now around 6-times, among the widest we’ve seen. 
  • Defensive stocks, for their current higher multiples, offer lower than average earnings growth and generally comparable dividend yields. Even with the hazy economic outlook, offensive stocks may in fact offer the better risk/reward, as a group.
  • The most extreme defensive stocks (predominantly utilities and food staples, and the only stocks in positive territory for the month of June) are the most expensive relative to forecasted earnings growth (a P/E of 22x on 5% annualized growth). Their average dividend yield of 3.3% may be favorable compared to bonds, but defensive stocks are not comparable to bonds, and should not be substitutes for bonds, in our view.

For what it’s worth, we do have several defensive stocks in client portfolios. We have below average representation, however—about 15% of the total large cap allocation, vs. about 30% in more normal times.. And the defensive stocks we own trade at more reasonable P/E’s of 14x.

The point here is that defensive stocks are indeed expensive and therefore present above average risk. They have uncharacteristically gone up more than the market, and if expectations for growth improve or rising rates emerge, they can arguably do worse than the market.

We Had a Glimpse of the Future This Spring

From mid-February to early April, investors began to contemplate economic growth and the potential for rising rates. This outlook was in contrast to the prevailing mood of the past two years—where investors sought yield and defense at almost any price.

Our Fundametrics® research system, which systematically tracks over 135 factors derived from fundamental company data, captured this shift. Exhibit 1 shows that Low Beta was the dominant factor for the trailing two years, as of February 5. Over longer periods, Low Beta does not dominate (nor does High Beta, for that matter). For this reason, we do not use Beta as a component to our buy/sell decisions[2].

For the three months ending April 22, the underlying market drivers reversed as they moved toward more normal states (Exhibit 2). Low Beta drove inferior returns, while important metrics like valuation offered rewards. The higher beta (cyclical, offensive) stocks began to perform above average as well.

After April 22nd, persistent fears about growth and lower rates returned, and the drivers of the past two years (Low Beta, etc.) returned to favor as well. Value factors as a group lagged again as well. Over longer periods, however, the value factors are much more meaningful in driving returns than Low Beta, by our analysis.

We do expect Investor Groundhog to emerge from his winter hibernation and go to where the opportunity is best.

Exhibit 1:

Factor Returns, Past 2 Years 

Exhibit 2:

Factor Returns, Past 3 Months


[1] Defensive stocks are typically those not meaningfully tied to economic activity. Examples are utilities, food staples, and basic services like Proctor & Gamble, Clorox, or General Mills. They tend to have low “beta” scores, which means they are less volatile than the market. They go down less, typically, and traditionally go up less, too. Offensive stocks, in contrast, more meaningfully reflect prevailing economic activity. They do best in an optimistic outlook, and do poorly when there’s pessimism about growth. They tend to have higher “beta” scores, meaning they are more volatile than the market. Volatility isn’t bad in and of itself—good companies can have higher beta scores. Think Juniper Networks, Caterpillar, Federal Express, or a(n) (inter)national bank.

 

[2] When a stock is in our portfolios, its beta score is simply a by-product of our value approach—i.e., if higher (or lower) beta has greater representation, it is because those stocks are more attractive at that particular time.

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