Beware of Defensive Stocks

by: Sy Harding

Just the thought of a double-dip less than a year after the economy began pulling out of the last recession is agonizing. Just the thought of another bear market in stocks so soon, with the S&P 500 still 30% below its peaks of 2000 and 2007, is unbearable for many.

Illustrating the emotional problem, in a recent e-mail dialog, the well-known anchor of a financial TV show explained to me why he is constantly arguing with analysts trying to warn investors, rather than letting them have their say, why he is trying to present a positive outlook for the market. He said, “My portfolio is still 36% below where it was ten years ago, and I am probably in a state of denial, unable to contemplate the possibility of another lost decade.”

It’s likely that many investors are in the same boat, still scarred by the back-to-back bear markets and hoping if they ignore the present threat that it will go away.

Unfortunately, the unpopular early warnings I have been planting in this column for several months are beginning to bear fruit. In last week’s column I noted that a double-dip is no longer considered crazy talk, but has now become the expectation of a number of credible economists, successful hedge-fund managers, and analysts. The possibility of a double-dip became more obvious in the last two weeks, with reports that retail sales unexpectedly declined in May, while real estate sales collapsed.

The outlook was not improved by the report Friday morning that economic growth in the first quarter, originally reported at 3.2% (down from 5.6% in the fourth quarter of 2009) was revised down to just 2.7%. The consensus forecasts had already been that economic growth will slow in the second half of the year. The downward revision of first quarter GDP, combined with the dismal economic reports for May, will force economists to revise their expectations for the second quarter, which ends next week, and for the rest of the year.

So this week has produced still more evidence that investors need to at least be careful and take protective action to preserve their assets.

Wall Street cannot bring itself to even recommend selling and moving substantially to cash to preserve capital, let alone providing advice on how to make profits in declining markets.

The most common advice for declining markets is to simply hold through whatever comes along. Those who have tried that in the past recognize the folly of attempting it after giving up and bailing out with large losses each time.

Wall Street’s backup advice is to move to defensive stocks, typically defined as companies that pay high dividends, and the big blue chip companies with international operations, and companies with the wind at their backs because even in recessions people still have to eat, drink, and take their medicines. Wall Street says they won’t go down as much as the overall market.

But is losing only 25% or 30% rather than 50% a credible way to handle a bear market?

And even Wall Street’s assurance that such ‘defensive’ stocks will lose less in a bear market is not based on facts. Just look at what happened to Alcoa (NYSE:AA), Coca-Cola (NYSE:KO), General Electric (NYSE:GE), Merck (NYSE:MRK), Bristol Myers Squibb (NYSE:BMY) - in fact, almost all defensive Dow and S&P 500 stocks - in the last two bear markets. Losses of as much as 65%.

Utility stocks are also often defined as defensive stocks since they typically pay high dividends. But the DJ Utilities Average plunged 61% in the 2000-2002 bear market, and 48% in the 2007-2009 bear market, about the same as the overall market.

Wall Street will have to change its bias if it expects investors to begin to trust its advice again. Constant bullish advice to buy only works in bull markets.

When serious corrections or bear markets threaten, investors need to pay attention and get their heads out of the sand. A good beginning would be to look into ‘inverse’ ETFs and ‘inverse’ mutual funds, which are designed to move up when the market moves down. There are close to a hundred available, each tied to different market indexes and sectors. Inverse ETFs include DOG, EFZ, PSQ. Inverse mutual funds include POTSX, BRPIX, RYURX. There are also leveraged ‘inverse’ ETFs like QID, SDS, DXD, and leveraged inverse mutual funds like URPIX, USPIX, RYTPX, which are leveraged and designed to move up twice as much as the underlying market index or sector moves down.

Making gains in down markets is a much better feeling than simply losing less by buying ‘defensive’ stocks.

Disclosure: No positions