It’s a rare occurrence when the words “consumer-staples stocks” and “bubble” are found in the same sentence.  But financial journalists are sounding a warning about the rising valuations of stocks in a variety of defensive sectors, including consumer and utility names.  These so-called “grandma” stocks have been outperforming more economically-sensitive names for the past two years and have lead the stock gains this year.  That fact alone is not a surprise, given that investors have little faith that the economy will grow fast enough to help more economically-sensitive stocks.  But with consumer-staples hitting forward price-to-earnings multiple of near 20, well ahead of their expected earnings growth, is it right to question whether these stocks are due for a fall.  Are investors paying too high a price for perceived security and dividend income? Is there now unappreciated value in the more cyclically geared sectors that have been cast aside?  Our answer to all of these questions is “yes!”

The table below shows the performance of the 10 sectors of the Canadian stock market thus far in 2013.  The TSX index in total is down 1.7% so far this year.  Clearly the resource sectors (Materials and Energy) have been the biggest drag on the market while the more defensive sectors have offset some of those losses.  Technology stocks have been driven higher by a few specific stocks in this small sector, including Blackberry (up 29%) and MacDonald Dettwiler (up 30%).  These resource sectors had a decent bounce last week, easily outpacing the 1.3% weekly gain for the TSX index overall.

Resources pull TSX down

In the end, either the global economy is expanding and the more economically sensitive sectors of the stock market will join the advance, or the economies are still in a deflationary mode, in which case all stocks, including the defensive sectors should suffer.  In either case it’s hard to make a good argument for the defensive sectors of the market to go even higher.  Our view is still that the global economy passed its crisis moments back in 2009 and that we are seeing an expansion, though muted compared to prior recoveries and hampered by the problems in Europe.  While the U.S. economy will continue to be supported by the recovery in the housing market and the subsequent positive impact on consumer spending and jobs, we think the bigger upside surprise could come from the emerging economies where the secular moves to urbanization will continue for decades.  China in particular should see growth maintained in the 7.5-8.0% range for the rest of the year, which would be a positive surprise.

Stocks are also undervalued in the emerging economies.  The MSCI Emerging Markets Index has a price/earnings ratio of 10.3 times, versus the U.S. average of 13.5 times forward consensus expectations.  Moreover, the average “cyclical” stock, whose earnings are linked to the strength of the global economy, has seen its valuation fall to only 9.6 times. The average “defensive” stock, meanwhile, has a P/E ratio of 15.1 times. The 5.5-point gap between the two is more than twice the average of 2.7 points since 1995.  The lack of ‘middle ground’ in this market forces investors to make a choice: Do they buy the expensive defensives and hope they keep rising or look for cheap cyclical stocks on the view that economic growth will remain positive and money will eventually flow back to this group due to its attractive valuation?
We continue to be bullish on the long-term outlook for stocks simply because they are, on average, well below historical levels, interest rates are expected to remain low for an extended period of time and the global economy continues to expand, thus supporting further earnings growth.  Although the ‘correction’ in stock prices didn’t come in the groups we were expecting, the market did pull back enough in April for us to feel comfortable adding to many of the same names we had sold earlier in the month at higher prices.  We added exposure in the Energy sector (Encana, Precision Drilling, Suncor, Crescent Point), Basic Materials (Potash Corp, Teck Resources, B2Gold, Freeport Copper) and Financials (RBC, ScotiaBank, CIBC, JP Morgan, Citigroup and Bank of America).

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