Should you worry that defensive stocks are leading the market?

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Market pundits have noticed that in the last month or so defensive sector stocks have surged ahead of aggressive stocks. They see this as a sign that investors remain tentative and are not ready to take on risk, despite the fact that stocks have been rallying since last November. They point to this seeming divergence between sentiment and reality as a worrisome sign, and view it as a reluctance to invest that doesn't bode well for stocks.

Defensive vs Aggressive stocks, 2013

But we looked back at years of data and concluded that defensive sector stocks in fact do better than aggressive stocks during established bull markets. In comparison, aggressive sector stocks offer better performance only during relatively short-term bursts during economic and market turnarounds. Instead of being a cause for concern, the outperformance of defensive stocks seems to be consistent with an established uptrend in prices.

Some businesses are highly dependent on economic activity, while some are not. Pretty much all of us wash our clothes regardless of whether the economy is in a recession or in a boom. On the other hand few of us would consider a pearl necklace a necessity, and we would only buy one when we feel that our personal finances stand to benefit from a growing economy.

Shares of Procter and Gamble, maker of Tide detergent, are therefore considered “defensive” stocks (or “non-cyclical”) because the company business is relatively immune to the ups and downs of the business cycle. Shares of Tiffany & Co., the jeweler retailer, are considered "aggressive" (or “cyclical”) because its business depends strongly on the strength of the economy.

Measures such as GDP show that the economy is almost always growing, even if at times the rate of growth is slow. An economy that is not growing is technically in a recession - an unusual state of affairs that governments try hard to cut short through various monetary and fiscal efforts.

Since growth is a “normal” state of affairs, one would think that those stocks that benefit from economic growth would on average do consistently better than those that are more defensive simply because the economy is much more likely to grow than to contract. Is that true?

In a word, no.

We analyzed one-year sector fund returns going back to 1988 by creating equal-weighted, monthly-rebalanced portfolios of sector funds. Defensive sectors include utilities, consumer staples, and health care, while aggressive sectors include construction, technology, leisure, consumer discretionary items, retail stores, and transportation.

First we looked at whether defensive stocks did in fact offer some kind of protection during times of weakness, as the name “defensive” suggests. We looked at instances when aggressive and defensive stocks go in opposite directions and we observed that, as expected, it is much more likely for defensive stocks to go up when aggressive stocks go down (83% probability) than the opposite (17% probability). In other words, defensive stocks offer better protection against market declines.

But we also found out that defensive stocks had a slightly higher annual return (12.6% vs. 12.5%) and much lower volatility than aggressive stocks (11.7% vs. 18.9%) for the entire 25-year history. In terms of risk-adjusted returns, then, defensive stocks deliver far better value for long-term investors.

Additionally, the maximum drawdown of the basket of defensive funds (i.e. the extent to which the basket can decline from a previous high) reached 39%, considerably less than the aggressive basket which lost as much as 51% at its worst point.

So why would anybody invest in aggressive stocks?

Aggressive stocks shine during economic and financial recoveries. After both large and modest market corrections, aggressive stocks sprint ahead of defensive stocks. The graphs below represent a sample of various instances when aggressive stocks recovered much faster than defensive stocks from a temporary market correction. After the initial sprint is over, however, aggressive stocks tend to sputter and that’s why they start registering temporary declines, letting defensive stocks “catch up.”

There is a parallel with large-cap and small-cap stocks. Large-cap stocks are shares of large, established companies that are relatively resilient to the ebbs and flows of economic activity. Large caps, therefore, can be considered “defensive” and small caps “aggressive.”

In a paper published in the North American Journal of Economics and Finance (The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada, Lorne N. Switzer, 2010) the author shows that small-cap stocks unequivocally and generously outperform large-cap stocks in the 12 months after the end of 14 out of 15 economic recessions going as far back as 1927.

Where are we now?

The worst part of the economic and financial pain of 2008-2009 is long past, and stocks prices, as well as economic indicators, have improved substantially. The discussion above suggests that at such late stage in the recovery the case for owning aggressive stocks is weak for long-term non-tactical investors.

Opportunistically speaking, aggressive stocks tend to rebound strongly from occasional market jolts.  But in the first few months of this year, with a well-established upward trend in stocks, aggressive sectors lacked the optimal conditions to thrive – i.e. a low point from where to recover faster than other sectors. In an established uptrend, defensive stocks do better. This has been reaffirmed in 2013.

Therefore, from a strategic, long-term perspective as well as from a tactical, short-term perspective, aggressive stocks do not seem well poised to deliver higher returns than defensive stocks at this moment.

This seems to be a technical feature of the market observable for at least a few decades. Those who point to the outperformance of defensive sectors as a worrisome sign, suggesting that investors are deeply insecure about the market, may be wrong. As far as we can see there is no apparent contradiction between the appetite for defensive sectors and the strong rally of this year. Defensive sectors actually perform better than aggressive stocks once a rally is established.

So exposure to defensive sectors seems to be the most sensible allocation to equities at this time, both because they perform well in established markets and because they decline less when the uptrend comes to an end. On the other hand, there is plenty of evidence that switching to aggressive sectors after market declines can yield additional returns. If the market were to experience a setback, aggressive stocks may well become the place to be for those nimble investors who are alert and willing to make the switch.

What now?

We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients, using a process that aims at identifying tactical opportunities such as the one described above - all along keeping an eye on controlling potential losses. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment processes works. We’ll be happy to set up a confidential meeting to discuss new paths to financial success. Read more