Since the inception of markets, there have been particular investments that garnered the attention of investors above all others. In the 1600s it was the tulip mania and at the turn of this century, tech stocks had investors’ focus. Although not to the extent of these examples, currently low-volatility dividend paying stocks are the rage du jour in this low-yielding uncertain market environment.
The lack of yield available on bonds has driven yield-thirsty investors to bond proxies for income, such as dividend-paying stocks. Global economic uncertainty, as well as academic studies that touted the merits of low-volatility stocks, have exacerbated the flow of money into this type of investment. In 2015, over $11 billion flowed into low-volatility exchange-traded funds and in the first two months of 2016, another $5 billion.¹
Utilities and consumer staples lie at the epicenter of this low-volatility, bond proxy trade due to their lack of economic cyclicality and higher than average dividend yields. This has led to stretched valuations in these sectors. Between 1995 and the financial crisis, the average price-earnings ratio of the utilities sector traded at a 25 percent discount to the broad market.² In contrast, utilities currently trade at a premium to the S&P 500 despite the sector’s lower growth and profitability characteristics. Additionally, the forward price-earnings ratio on the consumer staples sector is over 20 times on average compared to the S&P 500 at about 17 times. This represents one of the largest premiums for staples in the last 20 years.
Valuation is a poor timing tool because valuations can remain extended for long periods of time. If bond yields remain depressed and the global economy continues to slow or deteriorate, this trade could continue to outperform for the time being. However, when investors are looking for perceived “safety” in low-volatility dividend paying stocks, buyer beware. When any investment trade becomes too crowded, a reversion to the mean is likely to follow. This type of investment will be particularly vulnerable when interest rates eventually rise and their relative yield advantage dissipates. Certain investments will go in and out of favor over time which is why it is important to maintain a diversified portfolio with exposure to different asset classes, styles and sectors.