Financial Professionals

June 10th, 2016

Time to Invest Defensively?

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The title of this week’s column suggests I’ve turned bearish—I haven’t. We’ve said all year that we expect middling, but positive, returns from equities in 2016. In my view, we’re likely to see returns in the mid-single digits. Growth is slow, but it’s still growth. Also, as there are more tailwinds than headwinds occurring, we think corporate earnings will bounce positively in the second half of the year.
Still, there’s a compelling argument that we’re in the late phases of this bull market and economic cycle—an argument that holds water. There’s also historical precedent (which I’ll discuss below) that suggests defensive sectors and categories of stocks (like food processors and health care providers) will tend to outperform during sluggish times. For those who are a bit more bearish than others, you may want to reallocate investments in your portfolio.

Why Favor Defensive Sectors Late in the Cycle?

Over time, defensive sectors like Consumer Staples, Utilities and Health Care have tended to outperform during recessions and bear markets. Since 1963, each of those lower volatility sectors has almost always outperformed cyclical sectors during a bear market or recession (according to Vanguard Investment Counseling & Research). These include sectors such as Materials, Industrials, Energy, and Information Technology. Logic explains why: defensive sectors consist of companies that produce and sell goods for which demand changes little over time. Therefore, in a recession, many consumers strapped for cash will still spend on health care, ‘staple’ goods (paper towels, diapers, processed foods) and utilities (water and electricity).

Cyclical sectors experience opposite dynamics. During a slowdown, these companies pare back on activities such as building new factories while consumers hold off purchasing things like cars and luxury items. The relative earnings growth of defensive vs. cyclicals in down times tends to favor defensive sectors versus cyclicals, and stocks have historically reflected that shift.

A recent data point from ETF.com suggests an investor shift may be underway. Over the past two weeks, the Consumer Staples Select Sector SPRD ETF gained $333 million in net inflows relative to the much lower $105 million that flowed into the Consumer Discretionary Select Sector SPDR fund. Institutional investors also signaled some movement to the defensive—it was reported that the number of new institutional buyers (hedge funds, mutual funds) of Campbell Soup increased 92%, while new institutional owners of Coca Cola jumped 81%. If you’re wondering why that’s meaningful, consider this: Campbell Soup, a ‘defensive play’ was down 20.71% in 2008 while the S&P 500 fell nearly twice that (-40.18%), and Coke was down 29.55%.

Is Now a Good Time to Rebalance?

Arriving at the heart of the matter, the question is: should investors rebalance away from cyclicals toward defensive sectors? I still think it’s too early. To me, the odds of the economy and corporations surprising to the upside are about the same as the odds they perform in-line with expectations. In either outcome, it’s mostly growth across the board which means no bear market or recession. This suggests that defensive sectors may not necessarily shine on a relative basis, just yet.

Bottom Line for Investors

A well-diversified portfolio should have exposure to defensive and cyclical sectors at all times, which gives you a 100% probability of being allocated to ‘defensive’ names during difficult market periods. Where you tilt your portfolio is a tactical decision that you should base on where you see the economy and the market in the cycle, and what sectors and styles you think will perform best given economic circumstances at hand.

As we enter late cycle stages of the bull and economic expansion, I think it makes sense to favor larger cap, dividend paying names with stable earnings outlooks and defensive sectors as well. As the outlook turns less rosy, a tactical choice would be to incrementally shift to defensive, but not overly so. Just as defensive sectors tend to do well on a relative basis during challenging times, they also tend to under-deliver when growth is better than expected. I’m not convinced these times are as challenging as many believe them to be.

Disclosure

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.
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