With markets currently at or flirting with new highs, some investors are already thinking about the eventual reckoning. U.S. stocks have rallied, along with those of the rest of the planet, following the outcome of the first round of the French election. However, although more political stability in Europe is an unambiguous positive, as everyone knows, other risks abound. And that leads to the vexing question: How do you potentially manage those risks?
For equity investors looking to manage their risk there are two broad choices: raise cash or lower volatility. Historically, lower volatility has correlated with less exposure to the vagaries of the economy. This is generally found in companies in one of four sectors: health care, utilities, consumer staples, and telecommunications, often referred to as “defensives.”
Today the challenge is that many of these sectors have become expensive as bond market refugees have piled in searching for yield. I would exercise caution on U.S. utilities and consumer staples companies and instead focus on health care. Here’s why:
- Health care is relatively cheap. Since 1995, S&P 500 large-cap health care stocks have typically traded at a 10% premium to the market. Today they trade at nearly a 10% discount, close to a six-year low (see chart below). To some extent this drop in relative valuation is justified. Profitability is down from the glory years of the late 1990s when pharmaceutical companies were churning out a record number of blockbuster drugs. Currently the return on equity is roughly 18%, below the 22-year average of 20%. Still, profitability has been improving in recent years and is currently at the highest level since 2013.
- Historically, it’s been the best defensive play when rates rise. Consistent with other defensive sectors, health care stocks are often viewed as a bond market proxy. As such, their relative valuations tend to be influenced by interest rates. In other words, earnings multiples relative to the market typically fall when rates rise. However, given lower financial leverage compared to other defensive industries, health care is less sensitive to rising rates. For example, since 2010 the level of the 10-year Treasury has explained roughly 20% of the relative value of the health care sector. However, during the same period the level of long-term rates has explained nearly 70% of the variation in the relative value of the consumer staples sector. Put another way, trading consumer staples has been overwhelmingly a play on interest rates.
Investors worried about a correction need to consider not just the when but the why. With the exception of 2013’s taper tantrum, recent spikes in volatility have been driven by growth concerns. However, with the Federal Reserve firmly in tightening mode the next correction may be about rates, not growth. Under this scenario, some of the classic defensive plays, notably consumer staples and utilities, may not work as advertised. Health care is likely to be a better way to play defense.
The iShares Dow Jones US Healthcare ETF (NYSE:IYH) was trading at $159.36 per share on Thursday afternoon, up $0.70 (+0.44%). Year-to-date, IYH has gained 10.57%, versus a 6.73% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of BlackRock.