Santoli: Beware the high price for 'safe' stocks

Published Mon, Jun 6 20168:09 AM EDTUpdated Mon, Jun 6 20168:09 AM EDT

Overpay for prudence by too much and it can start to look like financial recklessness. Buying a $20 service contract for a $40 toaster is burning cash for the warm feeling of being protected. But what about paying bloated prices for an entire class of stocks whose main virtue is a reputation for steadiness and a trickle of cash income? This is the question facing the throngs of investors favoring "defensive" market sectors, especially those crowding into fund strategies engineered to promise most of the rewards of equity investing with a gentler rise. These include the PowerShares S & P 500 Low Volatility exchange-traded fund (SPLV) and iShares Edge MSCI Minimum Volatility USA ETF (USMV), as well as the sector funds tracking the utilities and consumer staples sectors. These stocks have been the clear leaders of a range-trapped stock market this year. They have gained appeal as stable dividend plays while bouts of downside drama have frayed nerves and global bond yields have continued their stunning descent. In this environment, the "less volatility with the same great taste" sales pitch of such investment vehicles is irresistible for many. The SPLV fund, for instance, boasts better returns that the Standard & Poor's 500 on a year-to-date, one-, three- and five-year basis, with somewhat less jumpiness. And, as with most strong trends, the popularity of this approach is rooted in some fundamental truth. Academic research suggests that in recent decades, lower-volatility stocks have produced better returns than some standard financial models would have predicted. And in a world scarce of yield, it makes some sense to view stocks largely as bond-like sources of compounding dividend yields rather than pure appreciation vehicles. That all makes for decent support for a tidy marketing message that nervous, crash-recalling investors nearing retirement might want to hear. Yet the price being paid must ultimately matter for future results. The global macro strategy team at UBS last week sounded an alarm over "near record valuations on these traditionally 'defensive' sectors." Consumer staples now trade above 20-times forecast earnings for the next year, compared with 14.2 times five years ago and 16.4 times for the broad S & P 500. The low-growth utilities group is at a 17.4 forward earnings multiple. This, of course, largely reflects the increasing value of the future dividend streams that are these companies' implicit promise to investors. Yet even without a sudden repricing of interest rates, stocks up at these valuations become vulnerable to small changes in corporate performance or market perception. In staples, it's worth reviewing the ride Campbell Soup has given shareholders. After a near-vertical surge in the first quarter, the stock flopped 6 percent in a day upon reporting earning last month and sits more than 7 percent off its May high. Hormel Foods , more dramatically, is off 22 percent since last month on modest shifts in investor posture toward its growth outlook. These anecdotal tumbles don't indict the "defensive trade" as a whole, but should prompt questions about whether this approach really offers enough of a buffer to compensate for the chance either that interest rates back up a bit or the market starts rewarding parts of the market more geared to the economic cycle. What's interesting is that the SPLV and USMV lower-volatility stock funds both have dividend yields near 2.2 percent — only a whisper above the S & P 500's yield of about 2.1 percent. And most those funds have a "beta" near 0.7, which means about 70 percent of their price movement is due to broad market fluctuation. This is the financial equivalent of learning the "light" version of your favorite snack is not all that much healthier for you than the original. The UBS macro team points out, too, that the vogue for throwing money at these equivocal strategies means the defensive market sectors have disproportionately high ownership rates by "passive" index funds. More than 21 percent of utility stocks and over 17 percent of staples names are owned by index funds. This suggests the stocks are acutely exposed to a potential indiscriminate rush of cash out of the low-vol strategies or a future interest-rate scare. While all this suggests excesses are building in this once-staid segment of the market, it's probably wrong to start declaring a "low-volatility bubble," as some have done. Mainly this is because a bubble usually requires a pervasive "greed narrative," a story of why an asset will deliver magical profits that's detached from historical reality. It's hard to consider "decent dividends and lets me sleep at night" as such a fantastical myth. And it's been hard to get behind constant calls of a "bond bubble" over the past few years for similar reasons — even though one could argue Friday's Treasury yield collapse looked like a buying panic, and assets in the main ETF to bet against Treasurys — the ProShares UltraShort 20+ Year Treasury — are down 40 percent since the 2013 "taper tantrum" bond selloff. Still, future returns can be disappointing and jarring even if the "safe yield" complex is not a toxic bubble. There are, however, decent options for investors who truly do just want some yield and stability rather than a sexy promise of "all the upside with much less risk." The lower tier of investment-grade corporate debt, as represented by the iShares Baa-Ba Rated Corporate Bond fund , holds bonds of many sturdy old companies with an average duration of under seven years, and a yield near 3.8 percent. And the always-neglected preferred stock market is rich with yield in a boring package. Yes, these are mostly bank preferreds, but the heavy capital requirements and regulations on banks support preferred stocks even as they restrain profits for common shareholders. The iShares U.S. Preferred Stock ETF yields around 5.8 percent, and many individual preferred stocks can be bought as easily as any other issue on the New York Stock Exchange.

Yellow "Caution" tape is displayed outside of the New York Stock Exchange.

Michael Nagle | Bloomberg | Getty Images

Overpay for prudence by too much and it can start to look like financial recklessness. Buying a $20 service contract for a $40 toaster is burning cash for the warm feeling of being protected.

But what about paying bloated prices for an entire class of stocks whose main virtue is a reputation for steadiness and a trickle of cash income?

This is the question facing the throngs of investors favoring "defensive" market sectors, especially those crowding into fund strategies engineered to promise most of the rewards of equity investing with a gentler rise.

These include the PowerShares S&P 500 Low Volatility exchange-traded fund (SPLV) and iShares Edge MSCI Minimum Volatility USA ETF (USMV), as well as the sector funds tracking the utilities and consumer staples sectors.