By Jacob Sonenshine
The prospect of elevated interest rates for longer has dented the broader stock market -- but history shows that is also the perfect environment for a select group of stocks to gain.
Inflation has remained too high for the Federal Reserve to lower interest rates soon, forcing the fixed-income market to send yields upward. Higher rates could lead to tighter financial conditions -- which translates to higher interest rates on corporate bonds, mortgages and other consumer loans, and credit cards, for example. That means consumers and businesses will have a more difficult time borrowing and spending money .
More economic stress could be on the way, and that means that a few groups of stocks can benefit.
22V Research screened last week for individual stocks that can outperform when financial conditions tighten, and most of the stocks are in the consumer staples, utilities, and healthcare sectors. Such companies typically don't see much of a hit to earnings when people and businesses slow down their spending. Utilities, specifically, can lift their service rates in the event that their expenses increase, as energy costs have risen recently.
The stocks on 22V's list have had a negative correlation in the past four years to tighter financial conditions: That means they tend to outperform the broader stock market when it becomes harder for consumers and companies to borrow money.
A few standouts -- among the 15 most negative correlations to tighter financial conditions in the past four years -- are Con Ed, McKesson and Coca-Cola. Other notable names included in the screen's 50 stocks are Hershey, General Mills, Kimberly-Clark, UnitedHealth Group, Vertex Pharmaceuticals and Duke Energy. The three stocks with the most negative correlations are the utility companies NiSource and Consolidated Edison, along with Jack Henry & Associates, a fintech and payments technology provider.
To be sure, S&P 500 staples and utilities have outperformed the broader index's roughly 4% gain since the end of January, when yields began their latest sprint higher. But all three groups look as if they have more room to continue to outperform.
These three sectors, quite simply, have more catching up to do with the S&P 500. In the past five years, the S&P 500 has gained about 80%, while the index's staples, utilities, and healthcare stocks have risen 38%, 13% and 61%, respectively, near their greatest degrees of underperformance in this time frame, according to FactSet.
Consistent with that, these sectors' valuations aren't as high as they could potentially become. Staples' average forward price-to-earnings multiple is a hair below the S&P 500's 20.2 times, but when the market is concerned about financial conditions and staples are in favor, their P/E ratios often rise above that of the index. Healthcare P/Es are also a tick below the index currently, but often surpass it when the sector is in favor. The same is true for utilities, which trade for 16 times earnings right now. This all means that investors are likely to pay an increasing premium for safety of these names going forward.
Buying these stocks and avoiding more economically-sensitive companies, which have suffered when financial conditions have tightened in the last four years, is a solid strategy. A difficult environment for borrowing and spending typically hurts sales and profits for restaurants, travel-related firms, retail and apparel, manufacturers, commodity producers and banks to name a few groups. Those are the stocks, generally speaking, to avoid.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
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April 25, 2024 14:10 ET (18:10 GMT)
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