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Market Warns This 'Safe' Sector May Not Be Investors' Best Choice

Michael J. Carr

Conservative investors often favor "defensive" investments like utilities, which are valued for their high yield and low volatility. Current market conditions, however, are warning that utilities might not be the best choice for conservative investors right now.

Stocks can be undervalued or overvalued. One way to profit from the market is to buy a stock when it is undervalued and sell when it is overvalued. This requires a definition of fair value in order to see where the stock price is (the current market price) relative to where it should be (the fair value price).

While there is no way to know what the true fair value is, there are a number of models that analysts apply to this problem. Analysts working for major Wall Street firms often provide the output of these models in the form of price targets.

Using the idea that the price target represents fair value, utilities are overvalued. The 10 largest holdings in Utilities Select Sector SPDR (XLU) are trading above their price target.

Industry data from Standard & Poor's confirms the overvaluation. Large-cap utility stocks are trading with an average price-to-earnings (P/E) ratio of 16.7, well above the average P/E ratio of 14.3 for the S&P 500 index. As a group, utilities are expected to see 4% growth in earnings per share, while the forecasted growth rate of the average large-cap stocks is almost three times higher at 11.6%.

P/E ratios and earnings growth rates can be combined into the PEG ratio, which is found by dividing the P/E ratio by the earnings growth rate. Stocks with a PEG ratio below 1 are considered to be undervalued. The PEG ratio for large-cap utility stocks is 4.2, making them the most overvalued sector in the market right now. Among mid-cap and small-cap stocks, utilities are similarly overvalued.

Investors seeking safety should avoid utilities and instead consider other defensive sectors like consumer staples. A similar analysis of the largest holdings in the Consumer Staples Select Sector SPDR (XLP) shows 8 of these 10 stocks are trading at least slightly below their price targets.

The PEG ratio for the consumer staples sector is 1.8, slightly overvalued but more reasonable than the utility stocks.

XLP recently gave a "buy" signal using the Momentum of Comparative Strength (MoCS) indicator. MoCS converts relative strength (RS) to a Moving Average Convergence/Divergence (MACD) style indicator. XLP is outperforming the S&P 500 when MoCS is positive.

Over the long term, it is usually best to own stocks or ETFs that are outperforming the broad market like XLP is now.

Current market conditions are more important than commonly held beliefs. Utilities are defensive stocks, but consumer staples are a better choice right now.

Recommended Trade Setup:

-- Buy XLP at $41.75 or less
-- Set stop-loss at $36.25, a resistance level from 2012 that should now be a support level
-- Set price target at $45.58 for a potential 9% gain in seven months

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