JPMorgan: Bubble in safe stocks ready to pop

Published Mon, Jul 11 201611:35 AM EDTUpdated Sat, Oct 14 201710:44 AM EDT

So-called safe stocks with low price volatility and big dividend yields are way overvalued and due for a big decline, JPMorgan told clients Monday. "This style is now up 74 percent relative to the market since the beginning of this cycle in '09, pushing its valuation to reach a new record high," said the firm's U.S. equity strategist Dubravko Lakos-Bujas in a note to clients. "Additionally, low volatility has become even more correlated to momentum, a vulnerable trade that has become increasingly crowded. This suggests low volatility may be in a bubble and subject to negative tail risk." Investors have crowded into these once slow and steady stocks after the U.K.'s Brexit vote, craving a safe, income-generating substitute for bonds as yields plummet to record lows, and even negative. The PowerShares S & P 500 Low Volatility Portfolio ETF is up 11 percent this year, more than double the return of the S & P 500 , which hit a new intraday high Monday. Here's what will pop this safety bubble and the stocks that clients should hide out in, according to JPMorgan. The firm examined the average valuation of low volatility stocks compared to growth stocks, and the differences are staggering. "The valuation multiple of low volatility is 30 percent above the levels justified by profitability and 10 percent above fair value based on dividend growth," the note said. "It is becoming harder to justify why this style is being valued at such extreme multiples in an environment where its leverage and growth spreads are becoming less attractive." Investors should watch for the following factors to judge when they should bail on the safe stock bubble. Once these occur, momentum traders could abandon the stocks quickly, JPMorgan said. "Surprises like a tick-up in inflation, rising yields, better than expected global growth print or consideration of new fiscal stimulus would leave low volatility type exposures vulnerable to sharp unwind," wrote the strategist. "Also, if interest rates actually begin to move higher, this will have a negative effect on dividend growth, which has been funded by lower and lower interest expense." These stocks are the most vulnerable to a sell-off: For those still craving safety and income, the following "low volatility stocks at a reasonable price" names may be immune to the sell-off because they have reasonable valuations and should be bought, according to JPMorgan. One more thing from Lakos-Bujas, the rally in these safe names could mean the overall market is headed for a big drop. Said the report: "There is an increasing disconnect between the equity market level and the underlying leadership. This suggests that we may either see a rotation in leadership, with low volatility type exposures facing negative tail risk, or this may act as a precursor to a market correction." — CNBC's Michael Bloom contributed to this story

Ross Gilmore | Redferns | Getty Images

So-called safe stocks with low price volatility and big dividend yields are way overvalued and due for a big decline, JPMorgan told clients Monday.