In a year full of surprises for the market (pleasant surprises, I might add), one of the biggest of all has been the stunning performance of defensive stocks -- those steady, low-beta stocks that tend to zig when the economy zags. These dull, stodgy securities, which Wall Street often derides as "widows' and orphans' stocks," are now as glamorous as the highfliers of yesteryear. Soporific sectors like healthcare, utilities, and telecom have led the market this year, rivaling the traditional bull market pace setter, consumer cyclicals.
As of last Friday, healthcare led the pack with a 20.6% gain in 2013, followed by consumer discretionary (up 19.6%) and consumer staples, which have gained 17.6%, according to Standard & Poor's Capital IQ. The S&P 500 has risen 14.6% this year, as of last Friday. It's the tortoise and the hare on steroids!
The explanation boils down to two words: yield and risk. The Federal Reserve's (and other central banks') extraordinarily loose monetary policies have driven interest rates down close to zero. Ten-year Treasuries yielded 1.94% Wednesday, high yield has become low yield, and longer-term Treasury Inflation Protected Securities lock in negative returns for the next 15 years.
In this environment, investors still licking their wounds from the financial crisis and market crash of 2008-2009 are willing to take a little more -- and I stress a little more -- risk to get some yield. So, defensive stocks, which usually pay dividends higher than the market, seem like a reasonable compromise between risk and reward. But when too many people think the same way at the same time, that's how bubbles begin. I'm not saying defensive, dividend-paying stocks are in a bubble -- that would take far more complacency and hysteria than we're seeing now -- but I do think they're overbought and due for a pullback.
Sam Stovall, chief equity strategist of S&P Capital IQ, isn't looking for a big correction in defensive stocks, but he said, "we probably could see some digestion of gains." "What's driving them won't necessarily change," he told me in an interview. "The people buying defensives aren't traders; they're seeking income." "A lot of income investors are sounding like Richard Gere in 'An Officer And A Gentleman': 'I got nowhere else to go!'" Stovall thinks the deal that averted the fiscal cliff and raised top taxes on dividends and capital gains to only 20% from 15% also helped push dividend-paying stocks higher. "Investors were given the green light by Congress to favor dividend-paying stocks over bonds," he said. "The inflection point was Jan. 1."
It's been off to the races since then. Long-time laggard Hewlett-Packard (HPQ) is up 48% thus far in 2013, Microsoft (MSFT) has gained 28%, and Johnson & Johnson (JNJ) has advanced 26% -- huge moves for stocks of this size. And despite their big recent run, defensive sectors are still trailing their economically sensitive cousins since the bull market began in March 2009. Consumer discretionary and financial stocks have both soared by more than 200%, double the gains of telecoms and utilities over the past four years.
Even so, defensive stocks aren't as cheap as they once were. At around 19 times annual earnings, defensive stocks were recently trading at almost a 20% premium to the market, according to Morgan Stanley and Bloomberg. Stovall agreed some sectors are pricey. Telecom stocks change hands at a 25% premium to their average since 1991, and utilities sell at an 11% premium.
The eight other S&P sectors traded at a discount, with technology the steepest at 40% below average. Healthcare, one of the defensive areas that have done the best, had the second biggest discount at 25%. But investors aren't buying because of valuation. They care only about yield, which is why the 4% dividends paid by telecoms and utilities may continue to attract buyers.
Still, there are signs of change. So far in May, discretionary, industrial, and technology stocks have led, while utilities and telecom actually lost ground. That's ironic, since this is the season ("sell in May and go away") when defensive stocks usually outperform while cyclicals falter. So far this year, it's been the opposite -- defensive stocks shone from November through April -- so they may not follow the usual pattern. And as long as rates stay low and these stocks' dividends are relatively high, investors will probably flock to them.
But defensive stocks are stretched pretty thin. So, though I wouldn't dump them entirely, I'd sell some of your highly profitable holdings in these sectors and wait for a sell-off until their prices look reasonable again. Or if you're truly a buy-and-hold investor, I'd hold on and collect or reinvest the dividends. But I wouldn't buy more now.