• Market leadership this year has not followed the traditional late-cycle trends
  • Defensive sectors have dominated, and ironically now appear overvalued
  • Investors may want to consider dividend growers

The approximate 6% return for the S&P 500 for the first seven months of 2016 might appear to indicate that market conditions are fairly ordinary, but the advance has been led by unexpected sectors.

Uncertainty during the first half of 2016 caused many investors to seek equity returns outside of traditional sectors that in the past have led the equity market after a sustained period of expansion and strong hiring. Historically, cyclical sectors such as consumer discretionary and information technology have been leaders in bull markets.

However, this year was different. Through the first half of 2016, telecommunication and utilities were the best-performing sectors, returning 24.85% and 23.41%, respectively.

Some market observers would assert that investors have become cautious, and therefore have gravitated to traditionally defensive sectors such as telecom and utilities. Others would argue that in a low-interest-rate environment, investors are searching for yield and have invested in “stocks that look like bonds,” as telecommunication and utility stocks also provide high-dividend payouts. These two sectors were not only the leading performers year to date, but also the two highest yielding sectors, with dividend payouts of 4.25% and 3.21%, respectively.

With better investment performance, however, comes higher prices, and the result is that the valuation of the utility sector has reached extreme levels. As the chart below indicates, the price-to-earnings ratio of the utility sector is over two standard deviations higher than its 25-year average and is at its second highest level since 1990. Note the subsequent underperformance each time valuations have reached these extremes. For example, the last time the utility sector valuation was two standard deviations more expensive than its average, the sector subsequently declined by more than 50%.

In the second-quarter Market Perspectives presentation, I discussed how high-dividend-yielding stocks were expensive relative to their historical valuations and how they were expensive relative to companies that grew their dividend. If history is any guide, investors may want to consider allocating away from high-dividend-yielding stocks and funds, which may be more vulnerable to a correction, in favor of dividend-growing stocks or value funds that embrace dividend growth.

We believe these fundamental trends are in place, although the timing of when they might play out is uncertain.

The S&P 500 Index is an unmanaged index of common stock performance. Indexes assume reinvestment of distributions and do not account for fees. It is not possible to invest directly in an index.

The S&P 500® Telecommunication Services Index comprises those companies included in the S&P 500 that are classified as members of the GICS® telecommunication services sector.

The S&P 500® Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS® utilities sector.