Enough With The 'Defensive' Stock Nonsense

by: Vince Martin

Summary

Every time the market shows weakness, the 'experts' come out to tout 'defensive' stocks.

But there's not much evidence that defensive stocks work.

And if investors are that good at market timing - why not short?

In my opinion, one of the most important things an investor can do - actually, must do - is stay humble. Particularly in the equity market, investing isn't easy, or simple; for every purchase or sale an investor makes, there's someone, and often someone very smart, on the other side of the trade.

As a rule, I try and keep humility in mind when disagreeing with other investors, whether on an individual stock or a larger strategy. But there's one concept in the market where I break that rule: the concept of "defensive stocks." Amidst a volatile start to 2016, that old trope has come back out: buy consumer staples, utilities, and other 'safe' stocks, to navigate a volatile market.

I truthfully can't think of a sillier piece of market advice, particularly for individual investors. I suppose there may be some logic for traders, but even that short-term case basically entails front-running other investors working on the flawed logic behind the original argument. Bear in mind, I'm not saying that the market doesn't, on occasion, rotate into defensive stocks (and/or out of cyclicals); certainly, it does. But advising investors to actively do so, as a strategy, is asinine for a number of reasons:

1. It's based on market timing.

Most investors I don't know don't necessarily believe in market timing. Some do, and there are commenters here and investors elsewhere who claim to have done it successfully themselves. (The most famous self-proclaimed market timer, of course, was Bernie Madoff.) At the least, it's certainly not easy, and even those who practice it point out how difficult a strategy it is from a psychological standpoint, and how marginal the returns are.

Whether or not investors can time the market, at best they can do so to a very limited extent (i.e., no one is guessing right 80% of the time what the market will do over the next month), and with quite a bit of technical expertise. (Perhaps not always; in Malcolm Gladwell's famous New Yorker article "Blowing Up," which introduced Nassim Taleb of "black swan" fame, George Soros' son was quoted as claiming that "the reason [my father] changes his position on the market or whatever is because his back starts killing him." Gladwell's point, and Taleb's point, of course, was that market timing expertise is highly overrated.)

For investors, it's not simple, or cheap (as opposed to traders, who admittedly could use SPDRs to attempt to benefit from projected trends). Commission costs and time spent matter; so does the fact that trying to time the market goes against most of the rules/principles/advice that work best for individual investors (stay patient, don't sell at the bottom, don't churn your returns away by making too many trades, etc. etc.)

Advising investors to time the market through sector rotation seems a dangerous, and costly, proposition. But it's perpetuated because it sounds conservative, and plays into the behavioral economics concept of "loss aversion." Someone who advises investors to "rotate" (a gentle word for altering a significant portion of one's equity portfolio) into "defensive" (there's that loss aversion again) stocks sounds reasonable. Imagine an 'expert' on CNBC giving the converse advice: every time you think the market is going up, sell your Procter & Gamble (NYSE:PG) and Wells Fargo (NYSE:WFC), and buy General Motors (NYSE:GM) and Caterpillar (NYSE:CAT) (or higher-beta names like Netflix (NASDAQ:NFLX) and Splunk (NASDAQ:SPLK)). He'd be laughed out of the room and sound like some pie-in-the-sky newsletter-pimping huckster trying to sell individual investors on a hugely high-risk "system."

But from a portfolio theory standpoint, there's no difference between the two, defining "defensive" stocks are lower-beta and "cyclical" stocks are higher-beta. The only difference comes if those "defensive" stocks offer higher long-term returns - in which case, there shouldn't be any advice to "rotate" into them, since they should comprise the equity portfolio regardless. What's missed in the advice - again, where the "loss aversion" concept comes in - is that this hypothetical rotation misses out on profits when it's incorrect. If you rotate at the bottom of a correction, your portfolio will lag the market on the rebound.

This also goes to the advice heard so often in 2008 to 2009 to simply buy blue chips in a plunging market. That too is questionable advice that sounds reasonable. But if - and this is a key 'if' - an investor thinks a market is oversold, he or she should theoretically be buying the riskiest stocks he or she can find, since those are the stocks that will outperform the most when the market returns. If an investor believes that the YTD 2016 performance is more a temper tantrum than the sign of a further collapse, then the stocks to buy are not semi-countercyclical McDonald's (NYSE:MCD) or safe-haven utilities; the targets should consumer-sensitive (and highly cyclical) stocks like non-invasive fat reduction provider ZELTIQ Aesthetics (NASDAQ:ZLTQ) or Harley-Davidson (NYSE:HOG) or boat manufacturer Brunswick Corporation (NYSE:BC).

(A note on the previous discussion: this is largely hypothetical, and on a relative basis; individual portfolio needs and desires, funding status, age, and all of the other investor-specific characteristics that drive trading obviously still apply. A conservative investor shouldn't buy HOG just because he or she thinks the last month of market trading has been overly negative. Nor am I arguing that investors should rotate into cyclical stocks at the moment, or at any point. The point is to point out the hypothetical converse implied by the "rotate into defensive stocks" argument. If it seems kind of silly, well, that's the point.)

From another standpoint, it doesn't matter whether market timing works; either way, advising to a rotation into defensive stocks in a weak market makes little sense. If market timing is possible for a particular investor - in other words, if that investor has a greater than 50% chance of predicting broad market moves over a time period into the future - then why simply switch to a different long position? If the investor is more than 50/50 to win a bet on market direction, why not use inverse ETFs ahead of projected weakness, or outright short ZLTQ, HOG, BC, and the like? And if an investor can't (or shouldn't) time the market, then why the @#$@#! are these 'experts' telling investors to time the market?

2. It doesn't work.

I covered this in a 2011 article, but defensive positioning didn't help much in the 2008-09 broad market collapse. (Forbes published had a different article in 2014 making a similar argument using different data.) Most sector ETFs in "defensive" categories - health care, consumer staples, and utilities - did outperform the market. But in the year leading into the March 6, 2009 bottom, the two largest dividend ETFs lost over 40% (against a 45% decline in the S&P 500), the Health Care SPDR (NYSEARCA:XLV) fell 29%, the Consumer Staples SPDR (NYSEARCA:XLP) 25%, and Utilities (NYSEARCA:XLU) 32%.

The performance of these traditionally "defensive" groupings was better than the broad market - but any investor with a portfolio of purely defensive stocks almost certainly still saw a 25%+ loss over those twelve months. (Incidentally, one of the best sectors to own over that stretch was the for-profit education industry.) And coming out of that bottom, those sectors underperformed the broad market over the next twelve months; returns from the SPDR Retail (NYSEARCA:XRT) were 115%, more than double defensive sector ETFs, and other higher-risk sectors showed even greater gains.

The moral of the story here is that portfolio allocation shouldn't get tied up with timing the market. None of this is to say that defensive stocks are inherently better or worse than cyclical stocks; an investor's appetite for risk depends both on that investor's circumstances and the rewards projected for that risk. (I'm short MCD and long Chegg (NYSE:CHGG), yet I'd argue the risk for the latter is much higher than the former.)

But the idea of "rotating" is simply put, garbage; it's based on an assumed ability to time the markets. That ability may not necessarily exist, and the attempt to do so is often cited as the biggest problem facing individual investors (they sell at the bottom and buy at the top). It's poor advice couched in reasonableness, like when a TV commentator says a football team should kick a field goal from the 1 yard-line down 9 to "stay in the game," even though the decision clearly limits that team's odds of winning.

Of course, in the case of the market, investors should just "stay in the game": stick with the portfolio allocation that is right for you. If risk is becoming a problem, change the portfolio, or hedge that portfolio (something much easier in this day and age). If you want to buy PG or MCD, buy PG or MCD. Just don't do it because some expert's back hurts.

Disclosure: I am/we are short MCD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long CHGG.