Monday's 331-point plunge in the Dow Jones Industrials (DJINDICES:^DJI) set investors on edge, raising fears that the 6-year-old bull market might finally be drawing to a close. In response, many nervous investors have looked at shifting the focus of their portfolios away from high-risk, high-reward stocks toward more dependable and defensive stock names. Indeed, this morning's activity within the Dow shows that trend: The average's best performers include low-volatility names like pharma giants Pfizer (NYSE:PFE) and Merck (NYSE:MRK), as well as consumer stalwarts McDonald's (NYSE:MCD) and Coca-Cola (NYSE:KO). Gains of 1% to 2% in all four of those stocks show the extent to which investors want safety, but buyers of those stocks might well get a nasty surprise if those stocks don't respond to the next market correction in the same way they have in the past.
Are defensive stocks the answer to a Dow correction?
The reason so many investors turn to stocks like McDonald's or Pfizer is that their share prices tend to move less dramatically than the overall market. Looking at their betas, the most common measure of share-price volatility, each of the aforementioned Dow components has a figure well below 1, suggesting that when the Dow moves 1% in either direction, they tend to move less.
During bull markets, owning too many low-volatility stocks typically leads to underperformance. Higher-volatility stocks benefit most in a bull-market environment, producing huge gains and developing momentum that often helps carry their share prices even higher. The trade-off, though, is that when the broader market falls, high-volatility plays tend to crash abruptly, while defensive names escape with more modest losses or even sometimes buck the trend and move higher.
Historically, investing in low-volatility stocks has produced good results going into Dow corrections. But there are reasons to believe they might not perform as well this time around.
Part of the appeal of low-volatility stocks in aging bull markets is that they tend to be out of favor. For the most part, their growth rates are far slower than you'll find elsewhere in the market, and traders who are frustrated with their relatively low returns abandon them in favor of better-returning stocks. That in turn tends to make them even more unpopular, which opens up opportunities for value investors to jump in at attractive prices.
This time around, though, investors have already gravitated to stocks like Pfizer, Merck, Coca-Cola, and McDonald's. Part of their appeal comes from their high dividend yields, which make them good income-producing investments in an environment in which portfolio income is hard to find. As a result, the stocks trade at earnings multiples that you'd more commonly find among high-growth stocks. McDonald's and Pfizer have trailing P/E ratios in the 18 to 20 range, which is only slightly higher than the overall market. But Coca-Cola trades at nearly 24 times earnings despite its struggles to produce growth, and Merck's earnings multiple of 32 shows the extent to which investors are counting on a full rebound in the pharma giant's net income to justify the current share price.
When markets correct, earnings multiples tend to be the first casualty. The higher the multiple, the greater the risk -- and that's especially true when high multiples don't have equally high growth rates supporting them. These four Dow stocks don't entirely lack potential growth-drivers, but they pale in comparison to other stocks in the market.
Low-volatility stocks have worked well to protect investors in the past. But when any stock gets overvalued, the risk that it will underperform the market rises substantially. With many defensive stocks valued at rich multiples to their earnings, the same catalyst that brings on the next Dow correction could well hurt those stocks more than those that trade at more attractive valuations.