Many investors make decisions based on either fear or greed. Unfortunately, such emotionally-driven behavior often results in poor decisions that can expose investors to a wide range of risks.
Recently, investors have been flocking to bond-like stocks, or the equities of defensive companies with steady earnings but little potential for generating earnings growth. In the process, investors have driven up valuations of defensive stocks and have overlooked the strong fundamentals of companies that are likely to reward investors by growing their earnings.
This trend among investors has created an attractive opportunity for advisors to add value by helping clients take a more rational approach to investing and by helping clients avoid, or at least manage, the risks associated with stocks that are perceived as defensive.
By way of background, investor sentiment weakened during most of 2015 and during the first month of this year. Last year, the International Monetary Fund routinely downgraded its forecasts for global GDP, commodity prices softened, and a strengthening U.S. dollar drove volatility abroad, especially in emerging markets.
Yet, slightly improving economic data helped investor sentiment strengthen in February, thereby sparking an equity rally with investors flocking to low-growth sectors. Broadly speaking, Consumer Staples, Utilities, and Materials sectors outperformed while sectors with promising growth potential such as Consumer Discretionary and Information Technology declined.
The end result is that the discount of growth stock valuations relative to value stocks has climbed to a level that hasn’t been seen in many years. In a similar manner, growth stocks are trading at substantial discounts to stocks with high dividend yields. A similar trend has also played out in many foreign markets.
With that in mind, advisors should contact prospects and clients and discuss why the trend of investors rushing to bond-like stocks is dangerous. Among other risks, advisors should explain that bond-like stocks, much like bonds, are susceptible to rising interest rates.
While interest rates are likely to be minimal going forward, even a small increase in rates could cause bond-like stocks to underperform, especially considering that the stocks are trading at high valuations.
To that end, advisors should consider creating charts that illustrate the impact or rising interest rates on dividend paying stocks or provide historical examples of how the stocks have performed when rates increase. The charts can be highly compelling,especially when considering that many investors think that they are taking a low-risk approach to investing by holding what are perceived to be defensive stocks.
Advisors should also emphasize that investors who have flocked to bond-like stocks risk missing out on the potentially strong performance of growth stocks. Indeed, low valuations have historically indicated that stocks have increased potential for generating strong gains, so growth stocks are well positioned to advance.
At the same time, large-scale trends, such as the growth of online retailing, digital advertising, smartphones, streaming media, medical breakthroughs, and other developments are creating attractive opportunities for companies to grow their earnings.
Regardless of expectations for the performance of growth stocks relative to defensive stocks, advisors should ensure that investors are managing risk by maintaining diversified portfolios rather than concentrating assets in bond-like equities.
Advisors should also point out that U.S. economic growth, while slow and inconsistent, is continuing. The job market is strong, real estate is strengthening, and consumer spending has been increasing with American’s spending power getting a boost from cheap energy.
Corporate fundamentals in the U.S. are also strong. While earnings in certain sectors have been hurt by declining oil prices and the headwind of a strong dollar on exports and foreign profits, many corporations have record-high cash balances and stock buybacks are occurring at a near record pace.