As the Dow Rises, Are Defensive Stocks Preparing for the Next Downturn?

Traditionally defensive stocks aren't posting the same gains as higher-growth Dow stocks or the broader Dow, suggesting that investors are getting more aggressive with their investing. Will that prove smart or ill-timed?

Mar 18, 2014 at 9:00PM

On Tuesday, the Dow Jones Industrials (DJINDICES:^DJI) gained another 89 points, adding to its rebound from yesterday and reasserting the positive trends that have support the average throughout the five-year bull market. But even as growth candidate Microsoft (NASDAQ:MSFT) soared almost 4% today, defensively positioned stocks Procter & Gamble (NYSE:PG) and McDonald's (NYSE:MCD) were among the few decliners Tuesday, and Wal-Mart (NYSE:WMT) only managed to post the smallest of gains on the day. As investors apparently get more comfortable with the prospects for stocks, will defensive stocks get left behind and finally fall back to more reasonable valuations?

The pros and cons of going out of favor
For years, investors have stuck by P&G, McDonald's, and Wal-Mart, even as they've all struggled with growth challenges that they've only partially overcome. For Wal-Mart, domestic competition has hurt its U.S. sales growth, as the retailer faces competition from below in the form of deep-discounting dollar stores and from above via traditional rivals like Target. Meanwhile, McDonald's and Procter & Gamble have suffered from a strong dollar, which has hurt international results at a time at which emerging-market economies have been struggling. Given economic conditions that already made growth challenging even in local-currency terms, neither P&G nor the Golden Arches can afford to have adverse currency impacts crush their results even further.

What has sustained these stocks for many investors, though, has been their lucrative dividends and their protection against market downturns. With yields between 2.5% and 3.5%, all three of these stocks have long histories of long-term stock performance, and the implicit protection against falling markets has helped keep shareholders satisfied even though their returns have lagged the Dow's overall performance substantially.

Because investors have looked for the protection of defensive stocks, earnings multiples have climbed to uncomfortable levels in many cases. P&G in particular, trades at 21 times trailing earnings and 17.5 times forward estimates, while McDonald's corresponding figures are 17.5 and 15.5 respectively. Wal-Mart looks like a relative value at 15 times trailing and 13 times forward earnings, but with none of the three stocks producing very much growth, it's hard to consider any of them true value stocks at this point.

Looking ahead
In assessing the Dow's future performance, be sure to keep an eye on these three defensive stocks. If the bull market is heading into its last stages, one would expect the highest-growth stocks to lead the way, leaving laggards better positioned to weather future stock market storms. Meanwhile, McDonald's, Wal-Mart, and Procter & Gamble all need to find ways to grow in order to sustain their own earnings, and that has been an increasingly difficult challenge for the three companies over the past several years.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Procter & Gamble and owns shares of McDonald's and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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