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It is a far too common theme that has been heard during the stock market rally over the last few months. Income-starved investors desperate to try to find attractive yields in an environment where interest rates are pinned at 0% are being encouraged to consider high-quality stocks that offer healthy dividend yields as an alternative. Some talking heads even go so far as to describe these types of stocks as "equity growth bonds" or "bond equivalents." While high-quality income-generating stocks certainly have their place in a more conservative portfolio strategy, suggesting that blue-chip stocks are somehow equivalent from a risk and principal protection standpoint is dangerous. For in the end, these are still stocks whose fate is largely tied to the broader equity market (SPY).

Some key fundamental facts differentiate blue-chip stocks from high-quality bonds in any market environment. Most significantly, stocks are inherently more volatile and are more challenging to consistently value for the following reasons. First, unlike most bonds where the coupon payment is fixed, stocks have cash flows from dividends that change over time. Sometimes dividends stay the same, but they also can be increased or cut at any given point in time. Second, while most bonds have a stated maturity date, stocks are perpetual securities with no defined time horizon or targeted future value where principal will be redeemed. Third, in the event of a bankruptcy, which is no longer unheard of for a blue-chip company over the last few years, bondholders are paid first and will typically receive something while stockholders get paid last and almost always receive nothing. Lastly, for those using fundamental analysis in the stock selection process, identifying price points and designating required rates of return are processes that are open to subjectivity to say the least.

A variety of additional factors make blue-chip stocks inherently more risky relative to their high-quality bond counterparts in the current environment. First, the quest for yield has sent investors flooding into blue-chip stocks over the last several months. As a matter of fact, some of what are considered the most stable and highest-quality names in the stock universe from the consumer staples, healthcare and utilities sectors are looking downright frothy so far in 2013. A bubble in defensive stocks? Nifty Fifty the sequel? Yes, anything is now possible in a world where central banks are flooding the financial system with liquidity every single trading day.

In order to illustrate this point, it is worthwhile to take a look at some specific examples. Let's look first at the largest name from the consumer staples space in Procter & Gamble (PG), which makes up a healthy 14% of the entire Consumer Staples SPDR (XLP). After chugging along through most of 2012, the stock exploded to the upside in early 2013 and is now trading at its highest valuation in years at nearly a 20% premium to its recent historical average. Yes, the 2.9% dividend yield is still very attractive with 10-Year Treasury yields at 1.7%, but it does come with a potential cost.

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On to the healthcare space. In keeping with our past example, we'll once again look at the top dog in Johnson & Johnson (JNJ), which is the largest name in the Health Care SPDR (XLV) at 13% of the entire ETF. Much like P&G, the stock was moving steadily along until the calendar flipped to 2013 where it hit an elbow, immediately sloping higher. Following this sharp spike, the stock is now trading at valuations last seen nearly a decade ago at a 35% premium to its historical average. And while the 3.0% dividend yield is alluring, it once again comes with a potential cost.

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Our last stop will be in the utilities space, where we will focus on two names. The first is Verizon (VZ), which is technically part of the Technology SPDR (XLK) and is its sixth-largest holding at roughly 5% of the ETF. Verizon has long been a favorite of the income-seeking crowd due to its dividend yields in the 5.5% to 6.0% range. But following the recent surge thus far in 2013, the stock is now only yielding 4.2%. This is certainly still attractive in our low-yielding world of today, but certainly not nearly as much as it used to be.

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The second name from the space where we will focus is the entire utilities sector as represented by the Utilities SPDR (XLU). While utilities clearly had some ground to make up for heading into the New Year, they have done so with an increasing pace. Much like many other names in the defensive space, utilities have been climbing higher with an increasing slope. And for companies that are largely slower growth businesses with high fixed costs, such a dramatic move is starting to feel a bit bubbly, particularly given the fact that the yield for the XLU that is typically in the 4.5% to 5.5% range is now down around 3.7%.

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It should be noted that the rampant rise in all of these names has coincided almost perfectly with the addition of U.S. Treasury purchases to the Fed's QE3 stimulus program on January 4. What is perhaps particularly notable is that the juice in stocks has increasingly bypassed the more cyclical stock market segments and has ignored the basic materials space almost completely. This alone says a lot about what type of results we can expect from the Fed's stimulus program in creating sustained economic growth, but this point is best left as a subject for another article.

Given that these high-quality defensive names are rising to the moon under the latest Fed stimulus program, why exactly then should the conservative yield-seeking investor worry? Because when stocks enter into parabolic rises, they are often followed by equally parabolic declines. And even the highest-quality stocks in the investment universe are not immune from dramatic declines.

Let's review the names introduced above to highlight this point. We will begin with Procter & Gamble. While it held up well during the early stages of the financial crisis in late 2007 and early 2008, it eventually capitulated and declined by nearly -40% from September 2008 to March 2009. And we should also not forget that P&G was one of the names at the center of the flash crash with an intra-day drop of -37% on May 6, 2010 before quickly recovering.

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The same story holds true for Johnson & Johnson. During the financial crisis, J&J dropped by over -35% in a matter of months. And it doesn't even need to be a crisis to see a high-quality name like this get hit, for it also dropped by over -13% in less than a month during mid 2011.

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Unlike P&G and J&J that held up well during the early phases of the financial crisis, Verizon bled lower throughout most of the 2007-2009 episode, losing over -45% of its value in the process. And like Johnson & Johnson, it lost nearly -15% over the course of a month in mid 2011.

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Even the typically counter-cyclical and stable utilities sector is not completely immune from the pain of a broad market correction. During the depths of the financial crisis, utilities stocks plunged by over -46% peak to trough.

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None of this means that investors should abandon their positions in these high-quality names. I have recently owned all of the names mentioned here and continue to hold both VZ and XLU today. But what it does highlight is the importance of keeping these positions in the right context. These are not fixed income substitutes. They are stocks, and they come with the inherent risks that are associated with investing in such securities. This is not to say that the bond market doesn't have its own problems right now, but that does not mean that investors should think that moving to the stock market is an appropriate alternative from a risk-control standpoint.

What about the argument that as long as you hold these blue-chip names through any short-term volatility that you will end up OK in the long term? It is true that many of these names have been most resilient over the long term in the face of extreme short-term price volatility. But this is not necessarily true of all names. Certainly, any long-term investors in Bethlehem Steel, Eastman Kodak and AIG can attest to this point. The more important point to emphasize, however, is just because stock prices have always rebounded from past sell-offs over the last 75 years does not necessarily mean that they will do so again the next time around. We are quite possibly approaching the end of what many refer to as the "debt supercycle." And with global central banks taking unprecedented steps to try and resuscitate the world economy, it is not beyond the realm of possibility that the next major sell-off may mark a long-term revaluing of asset prices that may see many stocks shed value that could take years to recover. For this reason, investors must at least be prepared to sustain the potential for a considerable principal loss if they hope to buy blue-chip stocks and hold them for the long term as bond substitutes.

So while investors are well served to own some high-quality blue-chip names to supplement income for their investment portfolios, they are equally well served to remember that these are indeed equities and should be handled as such from a risk-control perspective.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: When Blue Chips Bleed Red