Wall Street's advice on how to prepare for possible market corrections has always been the same. No matter what happens to the economy people will still have to eat, drink and take their medicine. So consumer staples, food, beverage, healthcare and drug companies will do well even in economic and market downturns.
Also on the list are large solid companies with stable earnings, particularly those like utilities that pay solid dividends that should offset declines in their stock prices.
As one prominent brokerage firm posts on its website, "Defensive stocks represent necessary items, like food, gas and medicine, and tend to change very little with the economic cycle because consumers are likely to continue buying them even in tough economic times."
Defensive stocks currently recommended by Wall Street firms include the usual: Procter & Gamble (NYSE:PG), Kellogg (NYSE:K), Coca Cola (NYSE:KO), PepsiCo (NYSE:PEP), Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD), Johnson & Johnson (NYSE:JNJ), Amgen (NASDAQ:AMGN), Pfizer (NYSE:PFE) and utilities companies.
However, investors need to be aware that while consumers will indeed have to continue to eat, drink and take their medicine, and therefore continue to buy the products of those companies, in a market decline investors do not have to continue to value the earnings of those companies as highly as during an exciting bull market. Furthermore, they do not.
In the enthusiasm of a bull market investors may be willing to pay 20 times earnings for a stock, while in the throes of a serious market decline they will perhaps pay only 12 times earnings for the same stock. Thus, although a company's earnings may continue to grow, even "defensive" sector companies see their stocks decline in value in a market correction.
For instance, in the 2000-2002 bear market, the recommended 'defensive' stocks included Alcoa AA), Bristol Myer Squibb (NYSE:BMY), Citigroup (NYSE:C), Coca-Cola (KO), Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae (OTCQB:FNMA), General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (NYSE:MRK) and Wal-Mart. They plunged an average of 59% to their lows, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.
The utility sector was also highly recommended as portfolio protection, since utilities are noted for paying high dividends. However, the DJ Utilities Average plunged 60% in the 2000-2002 bear market, more than the S&P 500's 49% decline.
In the 2007-2009 bear market, using ETFs as a proxy for the "defensive" sectors, while the S&P 500 lost 50% of its value, the Market Vectors Pharmaceuticals ETF (NYSEARCA:PPH) declined 43%, the Vanguard Healthcare ETF (NYSEARCA:VHT) plunged 42%, and the SPDR Consumer Staples etf (NYSEARCA:XLP) fell 35%. Meanwhile, the dividend-paying DJ Utilities Index plunged 48%.
Those were severe bear markets. How do "defensive" sectors perform in less severe 10% to 15% corrections? Let's look at their performance in the last one, the summer correction in 2011.
The Dow declined 16% in that correction. The Vanguard Healthcare ETF declined 17%. The Market Vectors Pharmaceuticals ETF declined 14%. The SPDR Consumer Staples ETF fell 10%. Meanwhile, the DJ Utilities Avg declined 13%.
History seems to show that repositioning a portfolio into so-called defensive sector holdings when risk rises for a market correction does not provide much, if any, protection.
Is there a better approach?
Moving to higher cash levels to avoid losses would seem to be one.
However, to borrow a phrase from sports, perhaps the best defense is a good offense.
Inverse ETFs are not merely defensive, but produce significant profits in market declines.
For instance, while the S&P 500 plunged 49% in the bear market of 2000-2002, the Rydex Inverse S&P 500 fund, designed to move opposite to the S&P 500, gained 96%.
In the 2007-2009 bear market, while the S&P 500 lost 50% of its value, the "inverse" ProShares Short S&P 500 ETF (NYSEARCA:SH) gained 86%.
You might ask how they could gain roughly twice as much as the S&P 500 lost. Keep in mind that a $100,000 portfolio that loses 50% of its value to $50,000 then needs a 100% gain to get back to even. The inverse fund's action of moving opposite to the trend of the S&P 500 is the equivalent of buying the S&P at its low and selling at its high.
Currently, it's not surprising that with rising concerns of a possible correction this summer, investors have been piling into the touted "defensive" sectors to such a degree that they are significantly outperforming the market so far this year. For instance, while the Dow is down fractionally for the year, and the S&P 500 up only 2%, the DJ Utilities Average is up 10.4%. The DJ Food & Beverage Index is up 10% just since February.
Perhaps it is that they tend to spike up on their perceived appeal as defensive positioning as markets approach tops, reaching more overvalued levels, which results in their larger than expected losses in the subsequent downturns.
In any event, as long as the market holds up they may be better than average holdings.
However, history shows that investors preparing for a potential correction by piling into "defensive" sectors, on the expectation that they will protect portfolios in downturns, are likely to be disappointed, to say the least.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.