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As the stock market has stalled and moved sideways since mid-February, with economic and inflationary worries increasing, Wall Street is beginning to put out advice on how to prepare for a potential market correction.

The advice has always been the same. You’ve heard it before. No matter what happens to the economy people will still have to eat, drink, and take their medicines. So food, beverage, healthcare, and drug companies will continue to do well even in an economic and market downturn. And large solid companies, particularly utilities, which pay high dividends that will help offset any decline in their stock prices, will also provide protection for portfolios.

But before you rush out to buy Coca Cola (NYSE:KO), Kraft Foods (KFT), Procter & Gamble (NYSE:PG), Sara Lee (SLE), Merck (NYSE:MRK), Bristol Myers Squibb (NYSE:BMY), or high dividend paying utilities like PPL Energy (NYSE:PPL) or DTE Energy (NYSE:DTE), be aware that while consumers will have to continue to eat, drink, and take their medicines, continuing to buy the products of those companies, in a market decline investors do not continue to value the earnings of those companies as highly as during an exciting bull market.

That is, in the euphoria of an exciting bull market rally investors may be willing to pay 20 times earnings for a stock, while in the throes of a market decline they will perhaps pay only 10 times earnings for the same stock. Thus even though earnings may continue to grow, most companies, ‘defensive’ or not, see their stocks decline in value in a market correction.

The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.

After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (NYSE:AA), Bristol Myer Squibb, Citigroup (NYSE:C), Coca-Cola, Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae, General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (MRK), and WalMart (NYSE:WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow’s decline of 38% and the S&P 500 decline of 49%.

The utility sector was also much recommended for portfolio protection since utilities are noted for paying high dividends. But the DJ Utilities Average plunged 60% in the 2000-2002 bear market, far and away offsetting any gains from dividends.

In the more recent 2007-2009 bear market, using exchange-traded-funds (ETFs) as a proxy for the ‘defensive’ sectors, while the S&P 500 again lost 50% of its value, the popular HLDRS Pharmaceuticals ETF (NYSEARCA:PPH) declined 43%, the Van Guard Healthcare ETF (NYSEARCA:VHT) plunged 42%, and the SPDR Consumer Staples ETF (NYSEARCA:XLP), fell 35%. Meanwhile, the ‘defensive’ dividend-paying DJ Utilities Index plunged 48%.

Of course those were severe bear markets.

So let’s look at what how ‘defensive’ holdings fared in the relatively mild correction of April-July last year.

The Dow and S&P 500 declined 15% in that correction. The Van Guard Healthcare ETF (VHT) declined 17%. The HLDRS Pharmaceuticals ETF (PPH) declined 14%. The SPDR Consumer Staples ETF (XLP) fell 10%. Meanwhile, the DJ Utilities Avg began to decline earlier and fell 13%.

Two conclusions could be drawn from this information.

The first is that there seems to be no reason to bother to reposition a portfolio into defensive holdings when risk rises of a market correction, or even of a bear market.

Yet the problem with standing still if you have reason to believe a meaningful correction is coming down the track at you, is that a 30% decline requires a 42% gain just to get back to even, while a 50% decline requires a 100% gain to get back to even. That’s why it’s usually a number of years before the market and portfolios get back to their previous levels.

The other conclusion, which I prefer, is that perhaps the best defense is a good offense.

That is, realizing that profits, rather than losses, can be made in market corrections.

For instance, while the S&P 500 plunged 49% in the bear market of 2000-2002, the Rydex Inverse S&P 500 fund (RYURX), designed to move opposite to the S&P 500, gained 96.5%. How could it gain almost twice as much as the S&P 500 lost? Keep in mind that a loss of 50% requires a 100% gain to get back to even, and the inverse fund was moving opposite to the S&P 500.

Inverse ETFs produce similar profits in market declines. In the more recent 2007-2009 bear market, while the S&P 500 again lost 50% of its value, the ‘inverse’ ProShares Short S&P 500 ETF (NYSEARCA:SH) gained 86%.

But, you say, it isn’t easy to know when a significant enough correction has begun to require action.

And that’s true. You won’t get out at the exact top, any more than you get in at the exact bottom when you’re buying. You can only strive to take a good chunk of profit out of the middle of moves.

It may be time again for investors to realize that profits can be taken from market moves in either direction.

Source: Don't Fall for the 'Defensive Portfolio' Hype