Investors have been paying up for ‘defense’… August 3, 2012

| Friday, August 3rd, 2012 | Comments Off on Investors have been paying up for ‘defense’… August 3, 2012

Investors have been paying up for ‘defense’.  This is reflected in many ways, probably the most obvious being the demand for US Treasury notes.  With the current yield on a 10 year note at 1.57%, the implied negative real rate of return is fairly clear evidence of the payment for defense and the flight to safety (or perceived safety).   There’s also some evidence within the equity markets of this mentality as well.  Take the utility sector for instance, which according to Thomson Reuters Baseline has traded at an average P/E discount to the SP500 of 20% over the last two decades, but now hovers at a 10% premium to the market – it’s peak relative valuation over that span.  Risk averse investors are seeking as much certainty as possible, and these generally stable businesses with nice dividends have attracted a lot of attention.  This attention however has resulted in valuation levels that do not appear as attractive as they have at other periods, and yields have shrunk as a result.  Though a good case can be made that high quality businesses with stable and high dividends deserve a certain level of premium, investors need to consider other factors, such as growth of that yield when determining the appropriate price to pay for a stock.

Below is a chart of the P/E ratios for a few of the top holdings in the Utilities Select Sector SPDR (XLU).  The market as a whole trades under 15x earnings, so these multiples illustrate the current premium for ‘defense’.  The issue for investors who may have large allocations to this sector is that from current levels, the defense may not end up being as hardy as hoped.

SO PE Ratio Chart

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