Market Suggestions: Don't Ignore Defensive Stocks; Don't Be Afraid to Sell

 |  Includes: DEO, FMCC, FRO, SPY
by: Elliott Gue

Since March the broader market averages have been on a steady climb higher, punctuated by only the shallowest of pullbacks.

Calls for a 5 to 10 percent correction reached a fever-pitch at the end of August as investors anticipated seasonal weakness for stocks in the dreaded month of September. But so far investors have bought every dip.

The US recession likely ended over the summer, and I’m looking for a cyclical recovery in the US and other developed economies over the next few quarters.

This outlook is based on my interpretation of battle-tested economic indicators such as the Conference Board’s Leading Economic Index (LEI).

In addition, credit conditions continue to normalize. A year ago, in the wake of the Lehman Brothers collapse, interbank lending rates spiked to unprecedented levels, and debt markets were in lockdown even for the largest and most creditworthy borrowers.

What a difference a year makes: Three-month LIBOR rates recently touched record lows, and even lower-quality borrowers are able to take on credit lines or sell bonds at attractive rates.

Much of the post-March 9 rally is predicated on improvement in global debt markets and a reversal of the panic that gripped the market late in 2008. If history is any guide, there will be further upside for the broader averages as a result of a cyclical economic recovery.

Nonetheless, don’t go whistling past the proverbial graveyard. The US and other developed economies face plenty of headwinds in coming quarters. Chief among these is a more sluggish, over-indebted consumer who will be less willing to spend than has been the case in prior recoveries.

The ballooning US federal deficit is another risk that can’t be overstated. The US government has already spent literally trillions of dollars trying to stabilize markets and the economy in a series of unprecedented market interventions.

Moreover, it’s hard to imagine a scenario where policies like health care reform wouldn’t add to the deficit. Eventually foreign holders of US government debt will demand a higher return on their money, and that spells rising US interest rates.

To make a long story short, I see the US and many other developed markets entering a period somewhat akin to the 1968-to-1982 market as measured by the S&P 500. There were plenty of profitable cyclical swings during this period, but the market marched in place.

In fact, thanks to the ravages of inflation, the purchasing power of a dollar invested in the S&P 500 in 1968 had declined by more than 60 percent by 1982.

To profit in such an environment, you need to be more nimble and selective; buying and holding a broader market index fund won’t produce the types of returns enjoyed during the 1982-to-2000 secular bull run.

If you’re like most investors, you’re likely sitting on some significant gains after the big rally off the March lows. You may also be worried about the potential for a near-term correction that would take back some of those gains.

For longer-term investors the best course of action isn’t to sell out of all your holdings and sit on cash. Do that and you’ll ensure that you miss out on some of the best rallies the market has to offer.

Two suggestions for the current market: Don’t ignore more defensive sectors in your zeal to participate in market upside, and don’t be afraid to sell some stocks.

One of the most straightforward and effective risk management techniques I know of is selling stocks.

I’ve always found that selling stocks is much harder for most investors than buying. After all, if the stock you’re selling is a big winner, you’ve probably become attached to the stock over time and are reluctant to sell and pass up the opportunity for even greater gains.

And an even bigger sin is holding onto losers and laggards; some investors fear selling losers because of the possibility that those names will turn around and eventually become winners.

I can also tell you first-hand that selling stocks out of a model portfolio is tough for newsletter editors. I always receive much more e-mail and telephone traffic after recommending a sale than after writing up a new recommendation. And if the stock rallies after that sell recommendation, the negative comments really start flowing.

Nonetheless, my sell calls have been among the most profitable I’ve ever made. For example, in late April I recommended selling two stocks from the PF Growth Portfolio, retailer Fred’s (NSDQ: FRED) and Frontline (NYSE: FRO).

The first had been a strong performer for months, but I felt had already priced in a great deal of good news; this turned out to be a less than controversial call, as Fred’s has basically trended sideways since that time.

Tanker operator Frontline generated a great deal more traffic. The stock had been a loser for us for months and didn’t look like a good play on a rebound in energy prices as tanker rates remained depressed. But in the immediate days after my sell call, the stock rallied sharply. The sale looked like a big mistake.

In retrospect, however, selling Frontline was a good idea. Although the stock is up more than 20 percent, it has slightly underperformed the S&P 500 and has underperformed my other energy-related recommendations by more than 15 percent.

Don’t forget there’s an opportunity cost to holding stocks; the money tied up might be able to earn a higher return elsewhere.

Go though your portfolio holdings and consider taking at least some of your profits off the table in big winners. Even more important: Look for those names you own that have massively underperformed the market in recent months and that you’ve been hoping would turnaround.

Chances are those laggards won’t perform any better during a market correction than they have during the rally. In most cases you’re better off selling and putting that cash to work elsewhere.

Another factor to keep in mind is that conventional wisdom isn’t always correct. I’ve read countless articles in major publications over the past few weeks advising investors to sell the consumer staples stocks; this industry group consists primarily of food, beverage and household products firms. The basic argument is that these are defensive stocks that tend to underperform the broader market during rallies.

That sounds logical until you consider that it’s just not true. During the strong market rally of 2004 through the 2007 highs the S&P 500 returned 47 percent and the S&P 500 Consumer Staples Index offered 43 percent, hardly a dramatic underperformance. Even better, the latter generated those returns with a good deal less volatility.

In fact, the S&P 500 Consumer Staples Index has outperformed the broader market in the six months following each of the last two recessions. In the wake of the 2001 recession, consumer staples were actually the best-performing index in the S&P 500.

I also believe that the group is transitioning from a slow-but-boring sector to more of a growth play.

First, in the developed world demand growth for most necessities is in line with economic growth. But in the developing world demand growth for certain products such as cosmetics, alcoholic beverages and household products is soaring and remained in the double-digits despite the global recession last year. Most big US and European staples companies are garnering an ever-larger shares of their earnings from outside the developed markets.

Second, I see the developed-world consumer becoming more frugal in coming years. The consumer staples firms are likely to benefit from this. For example, as consumers cut back on expensive restaurant meals, they’ll end up spending more on ingredients to cook at home.

And although going for a long holiday might not be in the cards, many consumers looking for a bit of luxury will be willing to mix a cocktail using their favorite branded spirits manufactured by the likes of Britain’s Diageo (NYSE: DEO).

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