I've written numerous columns over the past several years on defensive, long-term, investing strategies for principal protection, income creation and growth. The strategies discussed have performed phenomenally well, with positive returns far greater than the most commonly tracked stock-market indices. These have largely been lumped in two categories.
The first category is the super-cyclical stocks of companies involved in technology, which operate on a basis that is detached from the immediate economic environment. The sector that has performed best is biotechnology.
The second category is stocks of companies with products that are considered necessities, consumer staples and those purchased with disposable versus discretionary income. The best-performing sector there has been the grocers, but it has also included stocks of companies in the credit card space, insurance, utilities, mortgage lenders and more.
But a problem is brewing and it's important for long-term income investors and growth speculators to be aware of it. Because of institutional investors taking increasing positions in the defensive consumer staples space, stocks of these companies are now priced at a substantial premium to their historical averages and to the probable economic trajectory. Although the rate of appreciation these stocks have enjoyed over the past several years may continue in the immediate future, it is also mathematically impossible for that to continue in perpetuity.
The steady, low-volatility rates of return for stocks in these sectors over the past five years appears to have dulled investors' perception of principal risk that has increased because of the performance being substantially greater than economic activity. The best analogy I can think of is the mind-set concerning the appreciation rates of residential real estate in the early to mid-2000s, when even though by 2004 the rates were mathematically unsustainable, they continued to increase, and at an even faster rate between 2004 and 2007.
Stocks are generally discussed in four categories: large-, mid- and small-capitalizations, and technology. These are best represented as the Dow Jones Industrial Average, S&P 500, Russell 2000, and Nasdaq Composite. In the past five years, the performance of these indices, not including dividend distributions, has reflected expectations of imminent economic growth in the economy, with technology stocks outperforming small-caps, small-caps outperforming mid-caps and mid-caps outperforming large-caps.
The Nasdaq is up about 115%, the Russell 2000 about 98%, the S&P 500 is up 85%, and the Dow industrials are up about 70% in that period. The performance of the past two years, though, exhibits nascent signs of a different pattern developing. The tech-heavy Nasdaq still leads with a 50% return, but the S&P 500 slightly beats the Russell 2000 at 39% vs. 38%, while the Dow still trails at 29%.
The emerging pattern increases in the past year, with the Nasdaq still leading with a 16% return but with both the mid-caps, predominantly represented by the S&P 500, and the large-caps, represented by the Dow, leading the small-cap Russell 2000 with returns of about 13%, 10% and 5%, respectively.
The lagging performance of the small-caps versus the mid- and large-caps is indicative of institutional money crowding into the larger issues with greater liquidity, which usually means capital is being parked temporarily and in anticipation of the potential necessity of being liquidated quickly.
This trend is even more apparent by separating a subset of these companies into consumer staples versus consumer discretionary, rather than by market capitalization. The easiest way to track these is by the S&P indices for each: consumer staples and consumer discretionary. The annualized rates of return for consumer discretionary stocks for the past five-, three- and one-year periods, and YTD are 20%, 20%, 7%, and 2%. For consumer staples, they are 12%, 15%, 10%, and 9%.
The pattern shows investment capital shifting to staples over discretionary stocks in the past few years -- that is, to "needs" stocks catering to disposable income and away from "wants" stocks whose products are consumed with discretionary income. This is not what should occur if companies, investors and consumers expect the rate of growth in economic activity to accelerate. They are all acting on expectations of the opposite. This activity, however, has now resulted in needs-based stocks being bid above the economic fundamentals, too. This pattern was one of the reasons I wrote about pre-emptively switching from food distributors to food producers last July.
For now, that does not warrant an imminent correction in any of the defensive stocks I've written about, but income investors and growth speculators should be aware that they are now priced at a premium to historical valuations. In future columns I'll examine this issue more by considering similar patterns developing in financials, energy, technology, biotechnology and health care.