The Myth Of Defensive Stocks

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 |  Includes: BAC, CRM, DEF, DGT, DIA, JNJ, MCD, MS, PG, QQQ, SPY, WFC, XLP, XLU, XLV, XPH
by: Vince Martin

Back in August, I published a piece here on Seeking Alpha entitled "In A Downturn, Ignore The Pundits And Stay Aggressive". In it, I derided the oft-repeated conventional wisdom that investors buying into an undervalued market should be looking for high-quality "blue chip" stocks which were "on sale". I noted that market participants believing that the broad market was incorrectly discounting future stock performance should instead go after volatile, higher-beta, higher-growth companies such as small caps, tech names (semiconductors, for example), and emerging market stocks.

The corollary to that conventional wisdom, which is nearly as faulty, is the idea that amidst market volatility (such as we've experienced since early August) and potential downside risk, investors should rotate to "defensive stocks". This is a group which includes not only the blue chip dividend-payers mentioned above but also sectors such as utilities, consumer staples, and energy. (Not that long ago, financials and REITs were considered defensive as well. The one-month chart for Morgan Stanley (NYSE:MS) and your local real estate market ought to be enough to dismiss that notion.)

The standard advice for defensive stocks goes something like this, from USA Today in 2010:

When investors fear the economy is going to slow down or be weak, they gravitate to defensive stocks. The idea is that these companies' businesses will hold up. And that's why during recessions, defensive stocks and sectors tend to be winners.

Note: Some may argue that quoting USA Today on equity investing is like quoting In Touch on politics. Fair enough. But it was an investing column, aimed at the individual investor, and if you want more examples, search Google.

While "defensive stocks" may, on a relative basis, outperform other sectors amidst a broad bear market, it seems a stretch to call them "winners". Look at stock performances during the year leading into, and the year out of, the March 6 2009 intraday low of 666 on the S&P 500:

Defensive Stock Performance, Before & After 2009 Market Low

Index/ETF 3/6/08-3/6/09 3/6/09-3/6/10
DIA (Dow Jones) (44.96%) 59.44%
SPY (S&P 500) (45.34%) 66.31%
QQQ (NASDAQ 100) (37.30%) 76.97%
DGT (Global Titans) (46.51%) 58.36%
DVY (Dividend Stocks) (49.25%) 70.33%
SDY (S&P Dividend ETF) (41.17%) 75.86%
XLV (Health Care) (28.78%) 45.04%
XLU (Utilities) (35.64%) 32.96%
XLP (Consumer Staples) (25.14%) 41.90%
DEF (Defensive Stocks) (38.56%) 54.78%
XLE (Energy) (47.70%) 51.40%
XPH (Pharma) (19.35%) 69.23%
XBI (Biotech) (12.65%) 34.03%
Click to enlarge

(Please note: returns do include distributions, but do not assume that distributions were reinvested. Data sourced from marketwatch.com.)

What do we learn here? Well, defensive sectors were "winners"- if you were in a fantasy investing league where the object was to lose less money than your competitors. But losses still occurred: About 20-35% in defensive sectors such as pharmaceuticals, health care, and utilities. The fact that the broad market was off by nearly a half was surely of little consolation to conservative investors who correctly timed the market, only to see their portfolios fall by a quarter or more.

Now, it is likely true that the devastation in financial stocks, including mega-cap consumer names such as Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC), likely contributed to 2008-09 struggles in some of the ETFs listed, such as DEF, DVY, SDY, and DGT. Many of these ETFs had significant positions in retail and investment banking stocks, many of which paid solid dividends and were considered defensive stocks. That is until the entire sector imploded. (The Financials SPDR, XLF, lost 71% of its value in the year leading up to March 6, 2009.) But the long-term pattern of defensive ETFs remains the same: They do not, as often advertised, provide protection against downturns. They merely limit losses relative to the broad market -- and often don't function even that well. Let's look at the Guggenheim Defensive Equity ETF since its inception.

Click to enlarge:

DEF vs S&P 500, since inceptionClick to enlarge

DGT in blue; S&P 500 in red; chart courtesy Yahoo! Finance

Negative returns aside, DEF quite clearly has provided little protection against downside market movements. Perhaps the 2008-09 struggles can be blamed on an overweighting in financials and REITs, but what of the similar price action in 2000-2003, or the summer of 2011?

Looking at specific sectors, we see that financial exposure alone does not explain the failure of defensive stocks in the 2008-09 financial crisis. The Utilities SPDR (NYSEARCA:XLU) is a classic example of a defensive sector play. Utility demand is relatively inelastic -- consumers need power, and price and economic factors matter less than for nearly all other products. In addition, the solid dividends traditionally paid by the industry should cushion investors against a broad market downturn. Right?

Click to enlarge:

XLU ETF vs S&P 500, since inceptionClick to enlarge

XLU in blue; S&P 500 in red; chart courtesy Yahoo! Finance

Nope. XLU fell sharply from 2001-2003, and again in 2008-2009. (XLU shares have managed the recent two-month slide rather well, which may not bode well for the market as a whole. Note that XLU traditionally outperforms at the onset of a sharp downturn, as investors "flee to safety", only to underperform when the broad market fall accelerates.)

How about pharmaceuticals? Consumers always pay for their drugs, so surely...

Click to enlarge:

XPH vs S&P 500, since inceptionClick to enlarge

XPH in blue, S&P 500 in red; chart courtesy Yahoo! Finance

Wrong again. While pharmaceuticals have outperformed the market over the last five years, they have not been immune to corrections in 2008, 2009, and 2011, and actually saw stronger pullbacks than the market as a whole in the last two steep downturns.

You can run the charts for health care ((NYSEARCA:XLV)), dividend stocks (DVY and SDY), or global blue chips (NYSEARCA:DGT). The answer is always the same: defensive stocks fall when the market falls. It is true that they often are not devalued at the same rate as the broad market, but they usually don't rise as well in a bull market either. They are low-beta stocks. Indeed, from the chart at the beginning of the article, we see that utilities and consumer staples underperformed the market after it bounced off the March 2009 bottom.

As such, one has to ask: Why are we rotating into defensive stocks in the first place? If we are accurately able to time the market, why overload our portfolio with utilities, consumer staples, and blue chips, hoping for a 12% loss amid a 20% pullback in the S&P 500? Why sell Salesforce.com (NYSE:CRM) to buy McDonald's (NYSE:MCD), when we could just switch from long CRM to short?

Secondly, if we time the market incorrectly, we do serious damage to our returns. We wind up making the classic investing mistake: Selling our more speculative losers near the bottom, then buying defensive stocks and missing out on the super-sized returns afforded riskier stocks when the market rebounds. Indeed, the strongest performers in the 2009-10 stock market were high-risk, high-beta sectors such as semiconductors, financials, highly leveraged consumer stocks, and small- and micro-caps.

The advice to "go defensive" is doubly dangerous right now, as investors are likely flocking to a crowded trade. Market jitters and high volatility have led to the rise in gold, the lowering of Treasury yields, and modest returns in defensive sectors as part of a market-wide attempt to reduce risk. Indeed, the Utilities, Consumer Staples, and Health Care sectors of the S&P 500 are all up over 4% year-to-date, versus a 1% decline in the broad index.

None of this is to deny the value of stocks traditionally classified as defensive. Many of these companies deserve a place in nearly every diversified portfolio. However, investors should be looking at Procter & Gamble (NYSE:PG) or Johnson & Johnson (NYSE:JNJ) not because of economic fears, or the European debt crisis. Rather, they should be long those stocks because they are well-run, profitable companies with a history of top- and bottom-line growth, or because their dividend histories (JNJ has increased its dividend for 55 consecutive years; PG for 49) make them particularly suitable for income investors.

In short, there may be value in overweighting defensive stocks ahead of market volatility. The returns of those stocks over the last ten months show that. But everyone else knows that too. Here's a quote from Sam Stovall, chief investment strategist for S&P, via MSN Money (the quote is from 2010, but applies equally well today):

[Stovall] thinks consumer staples are due to shine in today's spooky market, because investors would rather "embrace more defensive sectors than bail out of stocks altogether."

And there's the catch. The investors crowding into defensive stocks to reduce risk are the same investors bound to bail on equities entirely at the first hint of trouble. Defensive stocks can outperform in a choppy market, even one drifting downward. But if the bears are right; if Europe continues to drag U.S. equities down; if a "hard landing" in China reverberates on American shores; and if the American economy continues to perform at or below "stall speed"; defensive stocks will fall, and fall hard, as those jittery investors finally "bail out".

What is especially frustrating about advising individual investors to take defensive positions is the vast array of hedging techniques now available. Options- whether purchased puts on the broad market or sold calls on individual positions- can provide far stronger downside protection for a small percentage of potential gains. The litany of inverse ETFs -- when used properly -- can also be used to mitigate risk. Individual investors now have a wealth of choices to protect their portfolios, most available at for relatively low commissions, many of which were not available even 10 years ago. There is simply no good reason to change portfolio weighting based on short- to mid-term market fears, when far more effective hedging strategies can be used with roughly similar transaction costs.

"Going defensive", while seeming to be a conservative strategy, actually does little to mitigate risk. Previous downturns show that defensive stocks have limited effectiveness against a broad bear market, while often underperforming when the fearful market turns bullish. There may be some short-term outperformance, as nervous investors search for "safety". But that safety is an illusion. Rotating into a crowded trade, which historically has not worked as promised, may delay damage to one's portfolio, but as has been proven repeatedly, it will not prevent it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.