The hidden risks in conservative stocks

As published in the Star Tribune 8/14/16.

With corporate bonds and U.S. treasuries carrying incredibly high prices for minimal returns, investors in search of higher yields have pushed up demand for dividend-paying stocks like utilities and telecoms.

Historically, these sectors have been less volatile than the average stock in the S&P 500 and therefore have been considered more conservative. But that label may no longer apply.

Just look at the sector’s price-to-earnings (P/E) ratio, which considers actual financial results (trailing P/E) or projected results (forward P/E) relative to share price. The higher the P/E multiple, the greater the price you’re paying for a stock.

Historically, the higher-growth sectors like technology trade with higher P/E ratios. Investors are generally willing to pay more for companies that offer faster growth. They typically pay less for slower growth stocks like utility and telecom companies. The trade-off is often a higher dividend and less volatility.

This year has been different. Stock mutual funds with the highest yields are the ones with the greatest inflows of new money. That demand has made utilities and telecoms the two best-performing sectors in the S&P 500, with year-to-date returns around 20 percent.

It has also pushed valuations to extraordinary levels. In mid-July, the utilities sector carried a trailing P/E ratio of 22.3, compared with a 10-year average of 14.6. In other words, based on earnings, utilities are 53 percent more expensive than their 10-year average.

In addition to the lofty valuations, the market’s highest-yielding sectors also carry an additional danger lurking below the surface: interest rate risk. Of the 10 sectors in the S&P 500, utilities, telecoms, and consumer staples have historically been most negatively affected by rising interest rates.

Global growth concerns and Brexit fallout have caused the Federal Reserve to delay its plans for hiking interest rates for now.

But the better the stock market and the U.S. economy perform, the more likely the Fed will be to restart its cycle of monetary tightening, potentially triggering a reversal of fortune for many high-yielding securities.

This isn’t to say that dividend-paying stocks are worth avoiding entirely. Many dividend payers deserve a place in a long-term portfolio. Investors simply need to be mindful of finding good value, especially when the goal is to reduce risk. Traditionally safe investments can become risky if you overpay.

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