One of my favorite market signals is flashing red, portending major weakness later this year and next.

Even as the S&P 500 has struggled to remain positive for the year, the Nasdaq has jumped 8.9% since January.

This lack of breadth in market strength is a tell-tale sign that exuberance in one segment of the market is holding prices up rather than general economic optimism.

It’s not a good sign when combined with higher interest rates, faster inflation and the potential for a trade war.

Fortunately for investors, some of the safest stocks to own ahead of market weakness just went on sale.

The sector has sold off more than 10% this year and pays a dividend yield 67% higher than the general market.

Aren’t People Still Buying Food?

Stocks in the consumer staples space, especially in packaged foods, are getting hammered this year. The Consumer Staples Select SPDR (NYSE: XLP) is down more than 10% against gains of 13% and 12% in out-performing sectors like consumer discretionary and technology.

First quarter results were weak on sales growth with negative to low single-digit revenue growth reported by most companies in the packaged food space. Full-year sales growth is expected at 4% for the sector, fourth-lowest of the 11 sectors tracked by FactSet Research.

Cost pressures, especially freight, are weighing on companies and weakening margins. Producer prices surged 5.4% from a year ago in May versus a rise of just 2.7% in consumer prices. Producer prices have grown at a faster annual pace than consumer prices since December 2016 reflecting inability of businesses to pass on costs to consumers.

General Mills pointed out spot rates for freight at 20-year highs and up to 60% higher than contract rates in its first quarter commentary. Other food processors have also pointed out high inflation in food commodities like vanilla and garlic, both up double- and triple-digits this year.

Many companies are fighting the rising costs with expense management and cost programs. The sector improved its aggregate net margin to 6% in the first quarter from 5.7% over the same period last year with three-in-four (76%) of companies reporting an improvement in margin.

Despite the weak fundamentals, these companies still benefit from business models rooted in necessary items and economies of scale that keep competitors out. That means solid cash flow and a dividend yield of 3%, well above the 1.8% yield on the general market.

Bear Market Safety Plus An Enticing Cash Yield

For investors worried about an end to the historic bull market, staples serve as protection hard to find outside of fixed-income. As the S&P 500 plunged 49% from peak to its 2009 trough, the consumer staples ETF fell a relatively mild 26% over the period.

With the recent selloff, the sector now trades at 17-times earnings expected over next year, a slight premium on the 10-year average multiple of 16.5-times but well off the 18.8-multiple over the last five years.

Against a broader-market valuation of 16.6 times forward earnings, a 15% premium to the 10-year average multiple, consumer staples are looking increasingly attractive and a few best of breeds are trading well into value-stock territory.

Campbell Soup (NYSE: CPB) has rebounded from May lows but still trades for a 25% discount on its 52-week high. Cost pressures caused the company’s gross margin to tumble 3.9% in the most recent quarter and forced out the CEO of six years.

The Board of Directors initiated a strategic review in light of the weakness and management has already committed to a program of $500 million in cost savings. A story in the New York Post speculated that Kraft Heinz and private equity might be interested in the company but it’s little more than speculation at this point.

Buyout or no, the company is one of the most diversified in packaged foods and some of the strongest brands as well. Shares pay a solid 3.8% dividend yield and trade for 16.4-times earnings expected over the next four quarters.

General Mills (NYSE: GIS) has been caught in the same cost pressures as Campbell is off its 52-week high by 25% and trades for just 14.9 times expected earnings.

The company holds a commanding share in many of its product categories including; breakfast cereal (30% domestic share), yogurt (18%), baking mixes (50%) and grain snacks (40%). The company is integrating its recent acquisition of the Blue Buffalo line of pet foods which should help support margins and further diversify the product mix. General Mills returned $2.8 billion to shareholders last year, nearly 10% of the market capitalization, while producing $2.3 billion in operational cash flow.

Philip Morris (NYSE: PM) saw shares plunge 15% after a first quarter miss on volume for its iQOS heated tobacco technology spooked investors. The selloff is a result of over-enthusiasm last year in the new segment and shares now trade for 15 times expected earnings.

Despite the tempered enthusiasm in the heated tobacco segment, the company still owns some of the most recognizable names in the industry and a commanding market share internationally. Shares now pay a 5.6% yield and produce $8.9 billion in operational cash flow annually, 7% of the market capitalization.

Risks To Consider: Even after the selloff, the consumer staples sector still trades around its average valuation on expected earnings. Cost inflation and weakness in sales growth could further weigh on the sector so target best of breed companies with more pricing power.

Action To Take: Take advantage of the recent selloff in consumer staples to pick up best of breed companies at value prices.

— Joseph Hogue

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Source: Street Authority