MorningWord 3/9/15: Yield to Gravity – $XLU, $XLP, $PG

by Dan March 9, 2015 9:27 am • Commentary

Friday was a bloodbath for high yielding equity sectors or those deemed to be defensive, with Utilities leading the way to the downside, declining 3%, and Consumer Staples and Healthcare down about 2%.

It’s not hard to understand why high yielding sectors like Utilities have outperformed (until recently). The average dividend yield of the top holdings in the XLU (Utilities etf) was above 3% prior to the 12% decline from the January highs. This, in an environment with ZIRP forever, where input costs have declined dramatically, and the strong dollar having had little effect on profits. But there was always an argument to be made against the price paid for that yield. It was not even double that of the yield on the 10 year Treasury yield, despite very low growth prospects and greater risk. Back in late December I made such an argument (New Trade – XLU: Utility Playa):

the components of the XLU are not exactly cheap, looking at the five largest holdings vs the S&P 500 trading at about 14.5x  2015 expected earnings growth of about 10%.  On average the five previously listed Uts are trading at about 18.5x expected earnings growth of about 5.5%.


Despite the generally dovish view of the U.S. Fed, but without QE in place, one would suspect a gradual rise in rates in 2015, especially if the U.S. economy continues to demonstrate its relative strength to the rest of the globe.  I am just not sure how Utilities can continue this sort of out-performance in the new year despite the perceived benefit of lower input costs from the decline in crude oil.

In hindsight this seems like a fairly obvious conclusion. The S&P 500 was a better bet at 14.5x which is below its long term average P/E than Utility stocks that were trading well above market multiples. Utilities did not appear to be pricing in the potential for higher rates in the near future.

And then there are Consumer Staples, perceived to be defensive because of the staple part and the high relative yield, but with one massive difference, large revenue exposure outside the U.S.   A prime example of investors being off-sides on this thesis was Proctor & Gamble (PG) heading into 2015.  The stock closed up 12% in 2014, less than 2% from its all time highs, with investors disregarding an earnings multiple at 7 year highs, despite consensus estimates expecting earnings and sales declines in 2015. But it was deemed defensive due to its 2.9% dividend yield.  PG has almost given back all of 2014 gains so far in 2015 after the company’s Q4 results and forward guidance confirmed that the adverse effects of the dollar have more than offset the benefits to the company and its consumers of lower oil.

Even now with the stock down 12% from its all time highs in late January, and its dividend yield now above 3%, (trading at 20x for no growth and no signs of dollar headwinds abating soon) I am not sure how one could call this stock “defensive” with the yield on the 10 year around 2.25%. And the failed technical breakout in Q4 2014 suggests a possible re-test of the 52 week lows in the high $70s;

PG 1yr chart from Bloomberg
PG 1yr chart from Bloomberg

I am not an investment adviser, and I have no experience crafting portfolio allocations, but it seems that investors have gotten lazy and complacent of late. The risk in these sectors seemed obvious at the time and even more so in hindsight.  I suspect that just as these stocks/sectors overshot on the upside, they may also do so on the downside, primarily a result of positioning and sentiment that apparently turned on a dime.