In early fall, you got a reminder of how risky stocks can be. The market sank more than 7% from Sept. 18 to Oct. 15, on fears that the global economic recovery was losing steam. Stocks eventually rebounded, with the S&P 500 and Dow back to setting record highs by early November. Even so, spooked investors did what you’d expect: They pulled $17 billion from equity funds and ETFs from late September to late October, while seeking shelter from the storm in the market’s usual hiding spots.
This flight to safety, which comes on the heels of several similar bouts of anxiety in recent years, has driven up valuations on conservative fare. This includes dividend-paying equities and “low volatility” stocks—you know, boring but stable giants such as Clorox or 3M.
Over the past half-century, low-volatility stocks have traded at about a 25% discount to the broad market, according to the investment firm Research Affiliates. Yet today many of these shares sport higher price/earnings ratios than the S&P 500. The same goes for dividend-paying stocks.
Why is this important? It means the market’s safe havens don’t offer as much protection as you think. Here’s what defensive-minded investors need to know:
If You’ve Been Loading Up On Safe Havens, Stop
It’s easy to see why dividend and low-vol stocks have been popular. Both strategies have beaten the market in downturns—as was the case in this pullback (see chart)—as well as over the long run.
Alas, rising valuations change the calculus. For starters, there’s no guarantee defensive stocks will hold up better in the next slide. In the October 2007–March 2009 bear market, the iShares Dow Jones Select Dividend ETF plunged 61%, vs. 55% for the S&P 500, owing to the fund’s large stake in financial stocks that were pricey at the time. “The higher the valuation, the greater the risk of a steep drop in a bad market,” says Chris Brightman, chief investment officer of Research Affiliates.
Meanwhile, there’s a simple reason why these stocks have traditionally beaten the market: “You’re really buying value investments, since they’re lower-priced stocks,” says Gregg Fisher, head of investment company Gerstein Fisher. Yet you can’t really make the case now that these shares are undervalued and therefore likely to outperform.
Focus on Real Value
If what you’re really seeking is the protection that low-priced stocks can sometimes provide, go with a traditional “value” fund that focuses on shares with cheaper-than-average P/E ratios.
Over the past 15 years, American Century Value has outpaced the S&P 500 by more than three percentage points annually. Yet in months when the market fell, the fund lost only around three-quarters as much, according to Morningstar. Prefer a passively managed option? Vanguard Value Index has also beaten the S&P over the past 15 years while falling less in down months.
And Don’t Forget Bonds
Say you held a 60% stock/40% bond portfolio in 2009 and haven’t reset that mix since. You’re now sitting on a 73/27 portfolio, as stocks have outpaced fixed income. If you’re in your thirties or forties you may not have to worry, as your lengthy time horizon warrants a big stake in equities.
If you’re older and your tolerance for risk has changed, then you may choose to dial back that stock allocation, perhaps even shifting more to high-quality bonds, says Vanguard senior analyst Chris Philips.
Aren’t bonds themselves frothy? Yes. And they grew more expensive in this pullback, as yields on 10-year Treasuries sank from an already low 2.63% to an even lower 2.09% before recovering. But here’s the thing: When bonds lose, they lose a lot less. The worst year for equities was a drop of 43%. For fixed income, it was only an 8% slide.
In fact, bonds made you money in the 2007–’09 bear. And isn’t that the ultimate defense—something that zigs when stocks zag?