Warning: This Sector Could Be The Next Bubble To Pop

Despite first-quarter growth slightly below expectations, I recently encouraged investors to relax and enjoy the market for at least another year until we see any real weakness in stock prices.#-ad_banner-#

I still think we have another year or two until the next great collapse, but I’ve found one particular group of stocks that may soon be on its way down.

Prices have surged for this group, and investors are paying a premium of up to 50% for these companies’ earnings. Even as the rest of the market continues upward, the bubble in these stocks is already starting to deflate.

What’s worse, this might be the last sector you would think would be prone to a bubble.

To be fair, there is a lot to like about the group. On average, companies in this sector have returned 68.4% during the past five years — more than double the 28.7% return in the S&P 500. The group also pays an average annual dividend of 3%, well above the rest of the market.

If you haven’t guessed, I’m talking about the consumer staples sector.

So what’s not to like?

A Lesson In Bubble-nomics
The past five years have seen a dramatic shift for stocks of dividend-paying companies in the consumer staples sector. With fairly stable but low revenue growth and high payout ratios, these companies were usually thought of as a highly defensive sector. Because of these companies’ relatively dim prospects for growth, the prices that investors have been willing to pay for earnings have usually been lower than those for growth stocks, such as in the technology or consumer discretionary sectors.

This has changed with investors’ fears of boom-and-bust market cycles. Scarred by two market bubbles in the past 13 years, investors are getting back into stocks by piling into the historically safest plays first. The huge inflow of money has driven price multiples skyward, but investors rationalize the hefty prices by looking backward at stable revenue growth.

The reasoning goes that earnings will eventually catch up to the share price, and investors will collect a reliable dividend in the meantime. As with most bubbles, this line of reasoning will be revealed as obviously (and painfully) flawed when the market realizes that future growth does not justify the lofty prices.

Reality Bites
Although earnings for the companies that supply food staples and household products should continue to increase, do we really need another lesson in prices getting ahead of earnings? The fact that technology giant Cisco (Nasdaq: CSCO) continued to increase earnings and lead its industry in innovation did not save it from falling 94% in the tech crash.

Valuation matters, and no group is immune to a herd-induced bubble.

Case in point: AT&T (NYSE: T) was trading at a whopping 30 times trailing earnings compared with an average of 19 times over the past five years. Shares jumped 17.8% over the past year to its most recent earnings report, more than twice the annual gain of 7% in the 15 year-period ending in 2005.

Why have the shares surged? Did the business fundamentally change, or did earnings growth jump to drive the stock higher? Neither. The jump in shares was purely a function of risk-averse investors piling in for a 4.8% dividend from a company that will outlive us all.

AT&T is a good company, but good companies can be lousy stocks when their shares have been bid up too high. Last month, AT&T posted a 5% drop — its biggest one-day loss in four years — when it reported that its first-quarter sales missed estimates.

The consumer staples sector is now the most expensive of all nine tracked by Standard & Poor’s Sector ETFs. The Consumer Staples Select Sector SPDR (NYSE: XLP) sells for 17.1 times 2013 earnings estimates, compared with just 12.9 times for financials and 14.2 times for the S&P 500.

Earnings reports seem to have been the tipping point for many of these stocks as investors realize the growth is just not there to support these high prices.

These three household names are due to report earnings in the next few weeks:

H.J. Heinz (NYSE: HNZ), whose shares have jumped by nearly 40% over the past year, is due to report earnings May 27. Shares received a boost in February when the company agreed to a $28 billion buyout from Warren Buffett‘s Berkshire Hathaway (NYSE: BRKA) and 3G Capital. A share price 23.6 times the past four quarters‘ earnings is more than 50% above the 15.6 average over the past five years. Earnings per share (EPS) is projected at $3.56 for 2013 — an increase of 6.3% over last year but not enough to justify the lofty stock price.

Hormel Foods (NYSE: HRL) is set to report earnings May 23 after a nearly 45% jump over the past year that has pushed its price to 22.6 times trailing earnings. That price multiple is 45% higher than what investors have paid for the shares over the past five years.

J.M. Smucker (NYSE: SJM) reports June 1 and is trading at a 30% premium to its historical price-earnings ratio after a 35% increase over the past year. Investors frustrated at the meager 5.8% annual gains in the shares over the long term have been rewarded over the past year, but they may want to cover their positions going into the earnings report.

The table below shows the performance of the three stocks over the past year compared with their compound annual growth rates from 1990 to 2005. All three stocks trade significantly higher than their five-year average price-to-earnings (P/E) ratios. These companies pay out a significant amount of earnings as dividends, and the slow rate of revenue growth over the past five years limits growth in future earnings.

*Long-run P/E average found by averaging high/low TTM for each of past five years, then taking average of five years.

Risks to Consider: If anything emerges to knock the market back from its bull trend, then these stocks could continue to do well as defensive plays. Even in that scenario, these shares have risen far beyond what their fundamental growth justifies, and investors could eventually pay the price.

Action to Take –> Many of these stocks are long-term holdings in a diversified portfolio and bring in a respectable dividend, making the decision to sell difficult. At minimum, investors may want to take profits on a portion of their holdings without completely selling out of a stock. In any event, investors should exercise caution and watch the valuation in shares.

P.S. — If you’re looking for a smarter, safer, and more profitable approach to income investing than you may be following now, then you need to know about Retirement Savings Stocks. Simply put, if you’re looking for a second income stream for your retirement, then it’s the only way to go. Find out more in this special presentation.