I’ve been warning all year about a clear and obvious bubble in consumer staples stocks. The same can be said for utilities and many areas on the fixed income market. This bubble has been built on the pervasive market sentiment that as long as the dividend yield is reasonably greater than what can be obtained in the 10-year Treasury bond, it makes sense to own these stocks as there just aren’t many alternatives in this low interest rate environment. Therefore, if the yield on the S&P 500 is 2% and 10-year Treasuries are yielding 1.7%, the lackluster financial advisor can say that stocks are the only place to be and because index funds have done well over the long-term and have low fees, one should just plow their assets into them. Almost all bubbles begin with what at first is a reasonable assumption, but then gets taken way too far after it becomes the “consensus” opinion.
The reason why this type of yield-chasing investment program is destined to lead to poor results is because there is no focus on valuation. Price is what you pay and value is what you get.
Many consumer staples companies such as Kellogg, General Mills, and Procter & Gamble were growth stories of decades past. That doesn’t mean that they can’t be good investments, but when you are paying 40% higher than historical valuations for them, despite their anemic or declining growth, you are setting yourself for permanent losses of capital. What makes it even more dangerous is that most people would agree that these companies aren’t going to be going out of business anytime soon so there is the presumption of safety. There is nothing safe about paying too much for an asset. Just think about housing prior to the Great Recession. Most houses structurally held up fine of course, but that didn’t prevent that value from getting cut by 25-50% depending on the region.
The rise of index funds is a very sensible phenomenon now taken to too extreme of levels. Investors that bought index funds in the late 1990s or 2000 had to wait 11 or 12 years to get back to even.
Value investors have long-term track records vastly superior to index funds over the long-term.
Index fund performance always looks best in late stage bull markets. These same overvalued stocks are continually bid up to higher prices through momentum investing in index funds as they become larger components of the indices. Buying begets buying and valuations keep getting more extreme until the bubble bursts.
While the index has been fairly flat to range-bound, many of these consumer staples stocks are down 15-25% and are still overvalued. Other areas of the market such as financials and technology have done far better and are still more attractive valued than these bond-like sectors. When interest rates do begin to go up, this trickling out of dividend-rich overvalued sectors, could become much more of a mass exodus. Ultimately it will create buying opportunities but the idea is to not take the 25-40% permanent loss of capital. Other areas of the market are much more attractive and offer very compelling investment opportunities, which is why we have been disciplined in our buying decisions.
In addition, we utilize conservative income-generating strategies such as cash-secured puts and covered calls to generate income and reduce risk.
These strategies allow us more alternatives than what are available to most financial advisors that are advocating these simplistic, yet unequivocally wrong recommendations.
Unfortunately, investing is not like sports. You can watch a football game on Sunday and it is very clear who the winner and loser is. In investing, you need years to go by and at least a full market cycle. Different strategies succeed at various stages of a bull and bear market. At some point there will be a shakeout and we just want to be on the right side of that, which I believe we are with positions in companies that would benefit greatly from interest rate increases, and that are trading at huge discounts to intrinsic value. I hope you enjoy the article below. Because it is a subscription site I added a few of the highlights right before the link. Thank you very much and let me know if you need anything at all!
- “Given the near-zero interest-rate environment of the past eight years, it’s hard to blame investors for seeking yield wherever it might be. That often means putting money in excessively risky assets. But it can also mean buying more-conservative assets with little regard to value.”
- “The normally defensive consumer-staples sector is a good example of the latter. Typically, investors flock to these stocks in times of uncertainty, with the added bonus that many of them also offer generous dividend yields.”
- “The problem is that fundamental valuations get stretched and even a technical analyst like me can notice when price/earnings ratios climb out of their typical ranges.”
- “For example, cereal maker Kellogg (ticker: K) peaked in July and has been falling ever since. It currently trades at a steep trailing 12-month P/E of 42. It offers a solid dividend yield of 2.8%, which is greater than that available on the 30-year Treasury bond.”
- “The real problem is that the stock now trades nearly 15% lower than it did at its highs this past summer. The Standard & Poor’s 500 index, by contrast, trades less than 1% below its July 2016 levels.”