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How to play smarter defense in a defensive market

Stocks appear to be slogging their way to new highs over the past year. Yet underneath the surface, it seems there’s been a good, old-fashioned rotation into more defensive stocks.

The best-performing sector so far in 2016 is utilities, known for its steady stream of dividends. The ETF tracking the utilities sector (XLU) is up over 22% year-to-date. As with fixed-income securities, low bond yields generally translate to higher prices for utilities stocks.

On a relative basis, other defensive sectors are also riding high, notes Brian Barnier, director at ValueBridge Advisors and co-founder of FedDashboard.com.

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He charted the Price/Earnings/Growth (“PEG”) ratio of several sectors using data from Zacks Research Systems. The PEG ratio takes the asset’s price and divides it by expected 12-month forward earnings to calculate a price-to-earnings (“P/E”) ratio. It then takes the P/E and divides it by the anticipated 3- to 5-year annualized growth rate.

Proponents of using PEG ratios argue that they take into account a security’s growth. For example, if two companies have similar P/E ratios, the one with the higher growth rate will appear cheaper. However, critics of the PEG ratio maintain, among other things, that two factors—forward earnings and expected growth rates—are highly subjective.

According to Barnier, the PEG ratios for several sectors are rallying as the market gets more defensive.

“The big growth in price-to-earnings-to-growth, where a higher ratio means a scary or high valuation less justify the fundamentals, are in… the nonresidential, non-retail REITs,” he said. The PEG ratio for utilities is also on the rise this year.

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Those looking to be prudent without suffering higher PEG ratios would do well to steer clear of typical defensive stocks and instead buy companies that show consistent earnings, recommends Barnier. He is particularly positive on the Zacks Earnings Certain Proxy, a measure consisting of several dozen companies that regularly produce steady earnings. It excludes interest rate sensitive and high growth stocks and includes old, reliable companies like Colgate-Palmolive (CL), Clorox (CLX), and Smuckers (SJM).

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Barnier advocates that more active traders looking to ride the sector rotation should look at PEG ratios relative to share repurchases because the latter may skew the earnings per share number. That’s because buybacks increase the current earnings per share at the expense of the value in cash used to buy the shares.

“If those PEGs are high and they’re buying back a lot of shares, that’s not a really good place to be,” he warned. “And on the other hand, if they’re low and they’re behind back a ton of shares…. that’s really not a place to be because all that buying back is hiding that that PEG ratio should be a lot higher, that the valuation should be much more stretched.”