Market Memo: Time to rotate


Many investors believe global economic conditions are improving. Yet their portfolios are still positioned with a Great Recession defensive bias, potentially reducing the returns they could earn from sectors that typically perform well during periods of economic growth.

For both the U.S. and international equity markets, defensive sectors such as utilities, pharmaceuticals and consumer staples, which have served as “bond proxies” for investors seeking yield, are now valued at significant premiums to their long-term, historical averages. By comparison, equity valuations are relatively attractive in the more economically sensitive areas of the market, such as consumer discretionary, industrials and materials, and even in the long-maligned financial-services sector. 

The rationale for a move into defensive areas of the markets was sound several years ago. Disappointing economic data, combined with heightened political uncertainty and other macro factors, compelled equity investors to take a cautious approach. As global equities rallied through this year’s first quarter, investors continued to pile into defensive stocks, drawn to the relative safety of these companies. Unfortunately, in the current market environment, there are risks inherent in this flight to safety, as premium valuations and an overcrowded trade leave little margin for error. 

Safety comes at a price
Let’s look at an example of two companies—one defensive, the other cyclical—and compare them. Nestle,1 one of the world’s largest food and beverage companies, currently trades at a multiple of 18 times 2013 earnings. The company has an earnings-per-share growth rate of 9% and a dividend yield of 3.3%.  For the last 10 years, Nestle’s average price/earnings (P/E) multiple has been 15.4, which means at today’s levels, the company is trading one standard deviation above its long-term average. That’s a 16% premium.  Investors are paying a premium for the perceived safety of a company that is expected to grow earnings by 9% on low single-digit sales growth.

On the other hand, Adecco,1 a temporary and permanent staffing company, is currently trading at 16.8 times 2013 earnings, which are expected to grow 62% year-over-year. Adecco provides investors with a 3.0% dividend.  After a nice run-up in the share price this month, the company is still trading near its long term P/E multiple, despite the better-than-average growth potential. While the company is recovering from depressed earnings, current valuations are not by any means stretched. 

Since the beginning of the year, global economic indicators have been mixed but we have been observing a general improvement overall in global economic activity. In June, according to Absolute Strategy Research, four of the five major indicators in the Global Manufacturing Purchasing Manager’s Index (PMI) rose, suggesting that a more broad-based improvement in the global economy is underway. Additionally, European PMI’s surprised to the upside, opening the possibility to an economic recovery in the second half of this year.

Performance of cyclical/economically sensitive companies and industries tend to move in lockstep with leading economic indicators. Investors who believe that the global economy is on the mend should consider altering the composition of their equity portfolios to take advantage of the attractive valuations, greater growth and capital appreciation potential of cyclical and financial services stocks.  While there is a place for high-dividend, income-producing stocks in every portfolio, it’s time to also consider cyclical stocks.

Taken from an article that first appeared on

1 Holdings in Adecco and Nestle represented 3.07% and 1.63%, respectively, of the total assets of Federated International Leaders Fund as of 6/28/2013. The holdings' percentages are based on net assets at the close of business on 6/28/2013 and may not necessarily reflect adjustments that are routinely made when presenting net assets for formal financial statement purposes.
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Investors should carefully consider the fund's investment objectives, risks, charges and expenses before investing. To obtain a summary prospectus or prospectus containing this and other information, contact us or view the prospectus provided on this website. Please carefully read the summary prospectus or prospectus before investing.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.
Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.
The Eurozone Purchasing Manufacturers Index (PMI) of manufacturing is a monthly gauge of the level of manufacturing activity in the euro zone.
The Global PMI is compiled by Markit Economics and is derived from surveys covering more than 11,000 purchasing executives in 26 countries.
There are no guarantees that dividend-paying stocks will continue to pay dividends. In addition, dividend-paying stocks may not experience the same capital appreciation potential as non-dividend-paying stocks.
Federated Securities Corp., Distributor
Copyright © 2014 Federated Investors, Inc.

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