Why Defensive Stocks Aren’t Safe Anymore

Hand holding american dollars against money backgroundNervous investors should think twice before diving into so-called defensive stocks, especially those securities with high dividends. You might end up putting more risk into your portfolio than you realize.
Stocks that have less volatility than the overall market and pay higher dividends than most other stocks are often seen as a way to reduce risk in a portfolio. Traditionally, these are found in the defensive sectors, including consumer staples, utilities and health care.

Given the state of the world, it’s easy to see why investors would want to get defensive. The war in the Middle East is certainty getting hotter. Cities are under the threat of terrorist attacks, and tensions between Russia and Turkey increased when Turkey shot down a Russian warplane on the Syrian border. Meanwhile, the European economy still looks saggy and the once-fast growing Chinese economy is decelerating. And the Federal Reserve looks set to start raising the cost of borrowing money sooner rather than later.

Sectors are trading at high multiples. The problem is that “the defensives are expensive,” says Ramona Persaud, portfolio manager for Fidelity Global Equity Income fund (FGILX), the Fidelity Dividend Growth fund (FDGFX) and the Fidelity Equity Income fund (FEQIX). Many of the traditional stock sectors that might once have helped reduce risk in a portfolio are trading at relatively high multiples.

She warns that investors could easily lose more money from a declining stock price than they gain from a healthy dividend.

In fact, that may already have happened to some investors. The Utilities Select Sector SPDR exchange-traded fund (XLU), which tracks a basket of utility stocks, has retreated around 10 percent this year, while the broader Standard & Poor’s 500 index (^GSPC) of major stocks is up slightly over the same time. Contrast that loss with the current 3.6 percent dividend yield on the fund. Clearly, those holding the fund since the beginning of the year would have resulted in a net loss, not including the effect of taxes.

Over the years, the Fed’s low interest-rate policies forced yield-seeking investors toward dividend-paying stocks like utilities, bidding up prices and valuations, explains Jeff Carbone, senior partner and founding member of Cornerstone Financial Partners, a wealth management company in Charlotte, North Carolina.

That yield seeking effect is now happening in reverse, with investors selling their holdings in anticipation of what Carbone says is an “imminent increase” in interest rates by the Fed. To reiterate, the pullback in dividend stocks like utilities was happening before the Fed has actually done anything. That anticipation of future event is normal in the stock market.

How do you find dividend stocks now? “Let’s find something with a similar yield that is growing,” says Mike Boyle, head of asset management at advisory Advisors Asset Management in New York. It is better to find stocks that are growing their income and will likely use those increased earnings to boost the dividend. “Focus on areas with strong earnings and income growth, like technology,” he says.
A good example of a company that is growing earnings and has a huge potential to grow its dividends is Apple (AAPL).

Using the combo approach also tilts the scales in the investor’s favor in the current market. You pay a lower multiple of earnings for a company that is growing its dividends. For Persaud, the trick is buying quality companies at a bargain. “Dividend growth is just cheaper.”

That’s why she purchased Israeli generic drug company Teva Pharmaceutical Industries (TEVA), which she purchased at a discount relative to U.S. pharmaceutical giants Bristol Myers Squibb Co. (BMY) or Pfizer (PFE).

Know the warning signs. Whenever you invest with the expectation of receiving dividends, you need to be on the lookout for potential problems.

“Usually when the yield gets unreasonably high, that’s a telltale sign something is wrong,” says Eric Ervin, CEO of ETF provider Reality Shares in San Diego.

For instance, if a stock usually yields 3 percent, but suddenly shows a 6 percent dividend, then that could be a sign that investors expect the dividend to be cut in half. Again, investors discount expected future events.

You should also look to see whether the payout of dividends as a ratio of earnings is sustainable. Companies do need to retain some of their income for capital expenditures and to buy back stock. If the payout is too high for too long, then management may be stretching things too far and it could eventually result in a dividend cut.

The average payout ratio of dividends to earnings is now around 40 percent for the S&P 500, Ervin says. Normally, it’s more like 50 percent, he says.

Market Wrap: Stocks Surge on Strong U.S. Jobs Data

Financial Markets Wall Street
NEW YORK — U.S. stocks rallied Friday, giving the S&P 500 its biggest gain since early September, as employment data suggested the economy was strong enough to sustain a Federal Reserve rate hike this month.

Financials, which benefit from higher borrowing costs, led the rally. The S&P financial index jumped 2.7 percent.

JPMorgan Chase (JPM) rose 3.2 percent to $67.89 after European antitrust regulators dropped charges against the bank on blocking exchanges from derivatives markets.

We’re going to see the market focused on what the U.S. economy is doing, rather than Fed policy.

But the rally, which followed two days of sharp losses, included most sectors and allowed the three major indexes to post slight gains for the week.

“Stocks are going to have to shift to a domestic economic performance focus. We’re going to see the market focused on what the U.S. economy is doing, rather than Fed policy,” said Brad McMillan, chief investment officer at Commonwealth Financial Network in Waltham, Massachusetts.

“I think we see a continued upward trend for the rest of the year.”

Nonfarm payrolls increased 211,000 in November, the Labor Department said, while September and October data were revised to show 35,000 more jobs than previously reported.

Analysts said the report, which also showed the unemployment rate held steady at 5 percent, most likely paves the way for the Fed to raise rates this month for the first time in nearly a decade.

The Dow Jones industrial average (^DJI)​ rose 369.96 points, or 2.1 percent, to 17,847.63, the Standard & Poor’s 500 index (^GSPC)​ gained 42.07 points, or 2.1 percent, to 2,091.69 and the Nasdaq composite (^IXIC)​ added 104.74 points, or 2.1 percent, to 5,142.27.

For the week, the Dow and Nasdaq were up 0.3 percent, while the S&P 500 was up 0.1 percent.

Nine of the 10 major S&P 500 sectors ended up. The energy index slipped 0.5 percent as oil prices fell on news that OPEC was planning to maintain its production near record highs despite depressed prices.

December Rate Hike

The closely watched employment report came a day after Fed Chair Janet Yellenstruck an upbeat note on the economy when she testified before lawmakers, describing how it had largely met the criteria for a rate hike. The Fed’s policy-setting committee will meet on Dec. 15-16.

Avon Products (AVP) rose 5.8 percent to $4.22 after a private equity investor group led by Barington Capital proposed a restructuring of the cosmetics maker.

Advancing issues outnumbered declining ones on the NYSE by 1,999 to 1,045, for a 1.91-to-1 ratio on the upside; on the Nasdaq, 1,840 issues rose and 965 fell for a 1.91-to-1 ratio favoring advancers.

The S&P 500 posted 22 new 52-week highs and 20 new lows; the Nasdaq recorded 69 new highs and 101 new lows.

About 7.7 billion shares changed hands on U.S. exchanges, compared with the 6.9 billion daily average for the past 20 trading days, according to Thomson Reuters (TRI) data.

3 Consumer Stocks to Covet in 2016

Inside A J.C. Penney Co. Store Ahead Of Earnings FiguresDescribing 2015’s stock market returns is like offering up reactions to toast with butter. [Meh. Yawn.]

While 2015 had some cringeworthy moments — like when China’s market took a dive this summer — for the most part, stocks are ending the year close to where they began, showing only a 1.5 percent boost in the Standard & Poor’s 500 index (^GSPC). It’s a far cry from the 63 percent return we saw through the three prior years.

Consumer discretionary companies, however, offered a bright spot. As a whole, the sector rose 12 percent; consumers have more money to spare, thanks to lower gas prices and unemployment, combined with higher wages. It’s a good time if you’re a company selling cars, homes or apparel.

But has the moment passed? With the Federal Reserve expecting to raise interest rates in December, tighter lending could persist. Although gas prices remain low, could oil soon become pricey again? And with seven-year long bull market rolling along, is it time for a correction? These are all primary concerns going into 2016.

To navigate this, we talked to portfolio and money managers to help find bright spots within consumer companies that could show signs of life, even if these issues become a problem.

American Eagle Outfitters (AEO). The Fed rate increase will certainly impact consumer companies. Historically, when rates move up, consumer discretionary and consumer staple companies perform the worst in the 12 months after the boost. But this isn’t your normal rate rise — unlike past increases, the Fed isn’t “really trying to tighten monetary policy, but normalize it,” says Brad Sorensen, an analyst at Charles Schwab (SCHW).

Since rates are already at historic levels, the increase isn’t to halt inflation, which remains low. Instead, it’s to move the rates back to a normal level. While typical rate raises hurt consumer companies, this time around they may be spared. But that doesn’t mean you should look to consumer-focused companies in droves. “We’re advising clients not to get too aggressive,” Sorensen says.

Instead, it’s time to get picky. One company that Jeannie Wyatt, CEO of South Texas Money Management, likes is American Eagle Outfitters. The stock fell 50 percent from 2012 to 2014 as teenagers shunned high-priced brands and American Eagle failed to control its inventory.

But in 2014, embattled CEO Robert Hanson left and American Eagle closed 100 stores that performed poorly. It has done a better job of making sure it’s not overstocked with clothes, creating a 17 percent return this year. Wyatt gives AEO stock a price target of $24, and the stock also pays a generous 3.1 percent dividend.

Group 1 Automotive (GPI). While gas prices sit near $2, there’s fear that they could rise in the next year, pinching consumer pockets.

Don’t expect them to change dramatically, though. Oil inventory levels remain high, which means there’s an overabundance of supply. This has continued even as consumers pump more gasoline. Outside of a major Middle East conflict or military intervention, Sorensen doesn’t see gasoline rising above $3 in 2016.

But there’s “not a lot of correlation between gas prices and consumer stocks,” he says. That’s because of other factors at play, like higher health care costs, which limit directly using funds saved from gas for mall purchases.

It does, however, push people to buy more gas-guzzling vehicles that offer many auto companies higher margins. One company that Eric Marshall, a portfolio manager at Hodges Mutual Funds, likes is the dealership Group 1 Automotive.

The average age of cars on the road is 11.5 years, a new high. When the economy struggled, people held off on purchasing new vehicles. And as improvements took hold, the last to feel the benefits were middle-class Americans. That has started to change, as wages increase and employment levels remain high. “We’re still in the early innings of the replacement,” Marshall says. “As long as employment is doing well, we think auto replacement consumptions will continue.”

Group 1 is cheap — GPI stock is trading at 11 times 2016 earnings. That’s below most of the industry, which trades 13 to 15 times 2016 earnings. Marshall has a price target at $110 for GPI stock.

J.C. Penney Co. (JCP) The biggest drag on a number of companies heading into 2016 may just be their outsized performances over the past few years. But that doesn’t mean the market won’t grow. You just can’t expect the large growth rates seen from 2012 to 2014. Sorensen expects growth next year of “mid-to-upper single digits.”

Finding companies that have much room to improve will be important since the ceilings for many stocks have already been reached. That can also mean taking a bet on companies that have struggled for years. Marshall sees that opportunity in J.C. Penney.

In many ways, Penney’s became a laughing stock of the retail world over the previous five years. Trying to adapt to weakening sales due to online shopping, it tried everything from marketing to higher end consumers, cutting back promotions and altering stores. They all dramatically failed. But now the company has gotten back to its roots with strong promotional plans, keeping its inventory at proper levels and cutting expenses.

While Walmart Stores (WMT), Kohl’s (KSS) and Macy’s (M) all see stagnating or falling same-store sales, it’s Penney’s that has better than 6 percent growth. And JCP stock is positioned to go up. “It’s been so bad for so long, it now has opportunity to gain back market share,” Marshall says.

The stock is priced at $8, which is the value that Marshall places on the company’s real estate alone. A fair price for JCP stock, he says, would be $16, which offers growth in a market where there’s little to find. “You’re buying the real estate, but getting the retailer for free.”

3 Risks of Investing in Annuities

USA, New Jersey, Jersey City, Close up of woman's hand putting money into jarInvesting can be scary, especially in the short term. When you retire, it’s hard to watch the value of your lifetime of savings fluctuate as financial markets bounce up and down. Fear is a powerful sales tool.

Immediate annuities are an insurance product that prevents you from losing money and offers the benefit of guaranteed payments. However, there is a catch with those guarantees. Many annuities aren’t guaranteed to keep up with inflation, so the purchasing power of those guaranteed payments could decline over time. Tying up a significant portion of your money in an annuity also takes away some of your financial options and flexibility, because you can’t always get the money back out easily. And some annuities are outright expensive.

Here are some of the issues you could face if you invest your retirement savings in an immediate annuity.

Inflation risk. Inflation has been artificially low for years due to manipulation by central banks and the slow growth patterns of the economy. As a result, many people have forgotten how inflation can reduce the buying power of fixed income payments and guaranteed rates of return.

Inflation is a normal occurrence as the cost of goods and services increase over time. Back in the late 1970s and early 1980s, inflation hit double digits.

A diversified investment portfolio has the ability to grow and provide a return above inflation. However, if you purchase an annuity in today’s low interest rate environment, you could find yourself in a situation where your “guaranteed” rate of return isn’t keeping pace with the rising costs of goods.

It wasn’t too long ago that the average rate of return on savings accounts insured by the Federal Deposit Insurance Corp. exceeded 4 percent at your local bank. With the Federal Reserve planning to increase interest rates, the risk of inflation should be factored in to any annuity purchase.

Loss of flexibility. Putting a portion of your savings into an annuity means that it won’t be available for current expenses or emergencies. Here’s how you limit your options when you purchase a guaranteed rate of return from an insurance company:

  1. Penalties. If you change your mind or incur an emergency expense and want to pull your money out of an annuity, you’re probably going to facesurrender charges. You could find yourself in the unfortunate situation of being subjected to surrender charges that exceed 10 percent. The insurance company is able to provide you with a guaranteed return due to the restrictive nature of the investment that makes it expensive if you want to withdraw your money early.
  2. No legacy options. Fixed annuities provide guaranteed payments during your lifetime. But when you pass away the payments typically cease, and your initial investment is retained by the insurance company. In some cases you can buy additional insurance riders that act as life insurance and repay the principal if you die unexpectedly. However, this additional protection has an extra cost that can add to the annual fees and ultimately lower the return or guaranteed payment, which is why you likely purchased the annuity to begin with.
  3. Limitations. Some annuities are designed to mimic the behavior of the stock market. Equity-indexed annuities supposedly make money like the stock market without the risk of losing principle. However, your participation in the returns of equity markets is capped or restricted. It varies by policy, but the limits typically kick in around 8 percent. That may sound generous, but consider how much money you would have been shorted in 2013 when the S&P 500 returned 32 percent. Make sure you read all disclosures and fine print before investing in an equity-indexed annuity.

High fees and commissions. Insurance products have multiple layers of fees. These can include mortality expenses, administrative costs and sales commissions. The fees can be steep. The Securities and Exchange Commission estimates that the average mortality expense is around 1.25 percent, and sales commissions are typically 5 to 6 percent.

Annuities are complicated insurance products with strict limitations on the guaranteed income. Given the current low interest rates and potential for increasing inflation, annuities certainly won’t be a good fit for everyone. Make sure the broker, agent or adviser you are working with truly understands your situation, needs and all of the investments available to you — not just the products that are the most lucrative for them.

Some tell-tale signs that you may need to seek a second opinion are:

  • A persistent recommendation of one product without clearly articulating (in easy to understand language) why it’s the best fit for you.
  • A limited knowledge of the entire realm of possible solutions, such as fixed versus variable products and immediate versus deferred annuities.
  • Recommendations that don’t make sense or that you can’t easily understand.
  • Offering insurance solutions for non-insurance problems, such as saving for college, paying off debt or emergency reserves.