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For a defensive bet, try cyclicals Add to ...

One of the conundrums of 2013 is why cyclical stocks look like such a steal next to defensives. Despite U.S. employment gains, a housing recovery and an ongoing bull market in stocks, investors have expressed a clear preference for companies that have little or no stake in an improving economy.

This preference has skewed valuations and in some cases inverted the usual risk profiles to the point where, if you’re looking for today’s bargains, cyclical stocks look awfully tempting.

Within the S&P 500, utilities, consumer staples and health-care stocks have gained about 18 per cent each this year. That’s about four-times the gain on technology stocks, more than double the gain on industrials and it also handily beats the gains on consumer discretionary stocks and financials.

One of the most convincing explanations for this outperformance by defensive stocks is that they typically have robust dividends, and investors are desperate for any income-generating products with government bonds yielding next to nothing.

As well, anyone who has a bearish disposition likes the fact that defensives might be better positioned for a market correction. According to the latest sentiment survey from the American Association of Individual Investors, this disposition is popular: Just 28 per cent of investors are feeling bullish about the market over next six months.

But the gains among defensive stocks have driven the price-to-earnings ratios to levels that now exceed many of the P/Es on cyclical stocks. Consumer staples have a P/E of 18.5, according to Bloomberg. Utilities have a P/E of 17.4 and health-care stocks have a P/E of 15.9. That’s more than 15.6 P/E for the entire S&P 500. And it’s a lot more than the multiples for tech stocks and financials, where P/Es are 12.5 and 13.4, respectively.

These valuation differences appear even more stark when you look at individual stocks. As Josh Brown at the Reformed Broker noted, Kimberly-Clark Corp. (a consumer staples company that makes toilet paper) trades at a higher valuation than tech giant Google Inc. What makes this particularly odd is that Kimberly-Clark’s 2012 net earnings were lower than 2010, while Google’s rose 26 per cent.

That doesn’t necessarily means that defensives are dangerously overvalued and ready to tumble, of course. As my colleague John Heinzl points out, dividend payers are still sitting on record amounts of cash and low payout ratios, pointing to higher dividend distributions ahead. The interest in dividend stocks, he argues, shows no signs of coming to an abrupt and painful end.

I agree: No crash. But at the same time, cyclical stocks are looking like a better bet than defensives if the economy continues to plod along or gain some traction. The fact that this isn’t a popular bet makes it even more appealing.

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