When market bubbles form, they usually start for a reason. The tech boom was fueled by revolutionary opportunities with the internet, and the housing bubble achieved liftoff from historically low interest rates and relaxed loan standards.

The problem is that investors quickly lose sight of reality and the enthusiasm for a sector becomes its own driver to more gains. Valuations are taken to the extreme and the market uses every excuse it can find to explain why fundamentals don’t matter.

#-ad_banner-#Eventually, something happens to weigh on the exuberance and investors have to reevaluate the real value of the investment… sending share prices tumbling back to fundamentals and historic averages.

One such bubble has been forming since stocks started to recover in 2009 and may be about to burst. In fact, this bubble has reached a point only seen twice in the last century… and both times turned out to be buying opportunities.

Safety Stocks May Not Be So Safe
Investors normally rush to low volatility and defensive stocks during market crashes, taking cover from uncertainty in other themes. The 30-year trend in lower interest rates, combined with historic monetary easing after the financial crisis, has brought a shift in the market and could be the next great bubble to pop. Low rates have pushed bond investors and anyone seeking yield into so-called ‘safety stocks’ in mature sectors paying higher dividends that are normally less correlated with the economy. 

Exacerbating the situation has been the uncertain recovery in global economic growth, further inflating the bubble in defensive stocks.

The total return of Consumer Staples Select Sector SPDR (NYSE: XLP) has jumped 218% since March 2009, well over the 193% return on shares of the SPDR S&P 500 Value (NYSE: SPYV) and the 198% return on the broader S&P 500. The consumer staples fund now trades for 23.2 times trailing earnings of companies in the group, a premium of 40% over the 16.6 times valuation on the value fund.

Looking at earnings and sales growth, the perception of stability in consumer staples starts to look a little shaky. According to Factset Research, the group posted a drop in earnings of -0.3% on sales growth of just 0.7% last year. Earnings for the first quarter are expected to be lower by -3.1% on sales growth of 1.9% compared to the same quarter last year.

Norm Boersma, CIO and President of Templeton Global Advisors, points to two other times when value stocks have underperformed defensive names by such a wide margin, 1942 and 2000, and both were buying opportunities.

Value stocks generally outperform defensive names in an economic recovery. Sales pick up and investors seek a little more risk for higher return. This risk-return tradeoff has broken down though and investors now seem to want higher returns and lower risk. On a three-year relative return, value outperformed defensive stocks by as much as 35% in the years leading up to the financial crisis. Recently, the value fund has underperformed consumer staples by 5% over the last three years and has only briefly outperformed since 2011.

What Will Cause The Safety Bubble To Pop?
Valuation in defensive names is only part of the problem. The bigger problem may be the perception of safety across minimum volatility funds and other sectors normally thought of as less prone to large market swings. As the Fed pushes rates back up from post-recession lows, the money that fled to yielding defensive stocks could migrate back to bonds.

As investor demand for the group wanes against higher rates on bonds, any catalyst could force a big correction in prices. Volatility could spike and investors would need to reevaluate the myth of low risk in the group and pricing the group on fundamental value alone. The consumer staples are trading for 21.1 times forward earnings, more than 26% above the ten-year average of 16.7 times expected earnings. 

The S&P 500 Value fund pays a yield of 2.56%, higher than the 2.36% yield on the consumer staples fund, and only a slightly higher annual volatility (16.7% versus 14.3%). Financials (24%) and energy (13%) make up the largest holdings, followed by health care (12%), industrials (11%) and a 10% weight in consumer staples. Financials may do well as the net interest spread widens on higher rates and the recovery in energy could lead gains for the rest of the year.

Risks To Consider: While value stocks have underperformed the defensive names, valuations have also crept up since 2009 and could be at risk to another recession.

Action To Take: Avoid the market bubble in defensive and seemingly low-volatility names for a better opportunity in value stocks and funds with a value theme.

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