The recent drop in the stock market has not spared so-called defensive stocks, which typically perform well regardless of the state of the economy. However, this unexpected turn of events presents a unique buying opportunity for investors.

The S&P 500, a benchmark index for the U.S. stock market, has experienced a nearly 5% decline from its year-high in July. The primary concern stems from the Federal Reserve's persistently tight monetary policy to combat inflation, which may lead to a weakened economy. Recent indications from the central bank suggest that interest rates will remain elevated for a longer duration than previously anticipated. The full impact of the cumulative 5-percentage point rate increases implemented by the Fed since March 2022 is yet to be fully realized.

Typically, defensive stocks tend to rise during such economic conditions. However, in this recent market environment, this pattern has not held true.

For instance, both the Utilities Select Sector SPDR ETF (ticker: XLU) and Vanguard Consumer Staples ETF (VDC) have declined by just over 7% and 5%, respectively, since late July.

The negative performance of defensive stocks stems from the more appealing yields on Treasury bonds, primarily due to rising bond yields. The yield on 10-year Treasury debt currently stands at approximately 4.4%, compared to just under 4% during the summer. As a result, these reliable dividend-paying companies find it difficult to compete with the higher bond yields. Forward dividend yields for staple stocks hover around 3%, while utilities offer just below 4%.

Given the lower yields of defensive stocks compared to bonds, it comes as no surprise that investors are divesting from these stocks.

Nevertheless, experts predict that the selling pressure is likely to taper off soon. Historically, utilities in the S&P 500 have lagged behind the broader index by approximately 60 percentage points since the end of 2018, a level of underperformance that typically stabilizes. Similarly, consumer staples have underperformed the S&P 500 by around 40 percentage points within the same time span.

Both types of defensive stocks have displayed a propensity for outperforming the market after a period of significant underperformance.

Oversold Stocks Show Potential for Reversal

According to a recent research note by Wells Fargo's U.S. equity strategist Chris Harvey, certain stocks are currently "oversold". This is an indication that these stocks have reached levels of overselling similar to what was seen in late 2018 and late 2021, before experiencing a significant turnaround. Harvey also points out that their relative value is notable.

Reasonable Valuations and Potential Upside

It's worth noting that these stocks are not expensive. For instance, the utilities fund trades at approximately 16.4 times the expected earnings per share for the next 12 months, which is a 9% discount compared to the S&P 500's valuation of 18.1 times. In the past, this fund has often traded at a premium, especially when it garners investor favor. If the economy weakens, investors may turn to these defensive stocks for stability, further increasing their attractiveness.

Similarly, the staples fund trades at around 19.1 times earnings, representing a roughly 5% premium to the market. However, it has the potential to trade at a more than 20% premium during periods of high favorability towards these stocks.

These reasonable valuations also mean that higher earnings could drive these stocks further upward. With utilities increasingly adding renewable energy plants and gaining regulatory approval for raising rates, it is expected that their EPS will grow by almost 8% annually over the next two years, based on FactSet data.

As for staples producers, although they have raised prices this year, the pace of these increases is expected to slow down. This slowdown is anticipated to drive an increase in the volume of goods sold, supporting moderate sales growth. Additionally, product costs are projected to rise at a slower rate as the Federal Reserve takes steps to combat inflation. The combination of these factors suggests the potential for higher margins, leading to an estimated annual EPS growth of about 9% over the next two years, according to FactSet.

Dividend Growth Outlook

Another factor to consider is the dividend situation. Dividend payments for both sectors are expected to grow in line with profit growth, which would boost the stocks' yields. In contrast, interest payments on Treasury debt remain fixed. This contributes to the appeal of defensive stocks at their current prices.

In conclusion, there are several compelling reasons to be optimistic about the potential of oversold stocks. The reasonable valuations, potential for higher earnings, and dividend growth outlook make them an attractive proposition for investors seeking more stable options in the market.

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