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Even with recent share-price gains, the yields on defensive stocks, such as McDonald’s, average 3.2 per cent, which is meaningfully above the average of 2.1 per cent for cyclicals. (Chris Bolin For The Globe and Mail)
Even with recent share-price gains, the yields on defensive stocks, such as McDonald’s, average 3.2 per cent, which is meaningfully above the average of 2.1 per cent for cyclicals. (Chris Bolin For The Globe and Mail)

Have defensive stocks become too expensive? Add to ...

You can call Tuesday’s action in the stock market a rebound from Monday’s rout if you want to.

But when you scratch the surface, the way up looked a lot different than the way down – and not just because the gains were about half the previous day’s losses.

More importantly, the S&P 500 on Tuesday was led by a mix of defensive and cyclical stocks – consumer staples and health care stocks were among the top performers for the day.

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Conversely, Monday’s nerve-rattling decline hit cyclicals far harder, with energy, materials, industrials, consumer discretionary and financials bearing the brunt of the selloff.

So it goes in 2013, where defensive stocks have been crushing their cyclical peers on the way up and the way down, raising questions about whether this latest phase of the bull market is being propelled by caution rather than optimism.

Sam Stovall, chief equity strategist at S&P Capital IQ, believes the charge into defensive stocks is only partly owing to bull-market latecomers staying clear of so-called high-beta sectors – which tend to be more volatile than the overall market – out of concern of a repeat of scary market turbulence.

Mostly, the favouritism is tied to a frantic search for yield. Defensive stocks have considerably higher dividend yields than cyclical stocks, on average, at a time when government bonds are yielding next to nothing.

But this preference for defensive stocks, whose gains are 50 per cent more than cyclicals since the bull market’s latest sprint began in mid-November, could be causing some market distortions: Defensive stocks within the S&P 500 have heftier valuations.

Mr. Stovall noted that they have an average price-to-earnings ratio of 17, based on estimated earnings. That is well above the 13.5 P/E for cyclical stocks and the 14 P/E for the entire S&P 500.

Defensive stocks are also pricier when looked at from a technical perspective: The average defensive sector is 10 per cent above its 200-day moving average, versus an average of just 2 per cent since 1994.

By comparison, cyclical stocks trade just 4 per cent above their 200-day moving average, versus a long-term average of 3 per cent.

If that looks like a good reason to avoid defensive stocks for being too, well, offensive, Mr. Stovall offers one good reason to stick around: Dividends.

Regular payouts contribute meaningfully to long-term gains and they tend to lower volatility in portfolios. And even with recent share-price gains, the yields on defensive stocks average 3.2 per cent, which is meaningfully above the average of 2.1 per cent for cyclicals.

“So even though stocks have soared, and the higher-yielding defensive groups have led the way, S&P Capital IQ equity analysts believe several stocks paying yields of 3 per cent or more are still attractive and deserve a second look by investors,” he said.

These stocks are: McDonald’s Corp., Altria Group Inc., General Mills Inc., Lorillard Inc., Chevron Corp., Pennsylvania REIT, Bank of Nova Scotia, General Electric Co., Waste Management Inc. and South Jersey Industries Inc.

Even broad baskets of dividend payers come highly recommended. S&P Capital IQ has an “overweight” recommendation on the SPDR S&P Dividend exchange-traded fund, which tracks stocks within the S&P 500 that have increased their dividends every year for at least 25 consecutive years.

Investors are paying a lot for dividends right now. But with payout levels historically low amid high corporate cash levels, the expectation that dividends will continue to rise looks like a safe bet.

 

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