With the U.S. economic recovery stumbling again, the eurozone debt crisis back in the headlines, and ‘Sell in May and Go Away’ on the minds of many investors, 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 in an economic or market downturn. And the stocks of solid companies that pay high dividends will also provide portfolio protection as the dividends will help offset any decline in the stock prices.
But before you rush out to buy stocks like McDonald’s, Coca Cola, Kraft Foods, Proctor & Gamble, Abbott Labs, Merck, Bristol Myers Squibb, or high dividend paying utilities like PPL Energy or Duke Energy, be aware of the actual history of so-called ‘defensive stocks’ during market downturns.
It is true that consumers will have to continue to eat, drink, and take their medicines, but investors do not have to continue to value the earnings of those companies as highly as they did in a rising market. Stocks that sell at 20 times earnings in a rising market may only sell for 10 times earnings when a correction makes investors more bearish and less confident. So even though a company’s earnings continue to rise, its stock will usually be dragged down by the falling market.
The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But Wall Street’s advice remains the same in every cycle. Don’t raise cash, just switch to buying and holding defensive stocks.
When the market was potentially topping out in 2000, stocks widely recommended as defensive, due to paying high dividends or being solid companies in industries sure to continue to do well if the economy stumbled, included McDonald’s, Alcoa, Bristol Myers Squibb, Merck, Coca Cola, Disney, DuPont, Fannie Mae, General Electric, IBM, and WalMart.
Defensive? They plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the 49% decline of the S&P 500.
The utility sector was also 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 surpassing the ability of the high dividends to offset the losses.
In the 2007-2009 bear market, using Exchange-Traded Funds (ETFs) as a proxy for the defensive sectors, while the S&P 500 plunged 50% in that bear market, the popular HLDRS Pharmaceuticals ETF (NYSE: PPH) lost 43%, the VanGuard Healthcare ETF (NYSE: VHT) plunged 42%, and the SPDR Consumer Staples ETF (NYSE: XLP) fell 35%. Meanwhile, the ‘defensive’ high-dividend paying DJ Utilities Avg. plunged 48%.
In the summer correction in 2010, the S&P 500 declined 15%. The HLDRS Pharmaceuticals ETF declined 14%, the VanGuard Healthcare ETF declined 17%, and the SPDR Consumer Staples ETF fell 10%, and the DJ Utilities Avg. lost 13%.
In last summer’s correction, the S&P 500 declined 20%, the HLDRS Pharmaceuticals ETF declined 15%, the VanGuard Healthcare ETF declined 18%, the SPDR Consumer Staples ETF fell 13%, and the DJ Utilities Avg. lost 12%.
Several conclusions could be drawn from that history.
The first is that there seems to be nothing to gain by repositioning into so-called defensive holdings when risk of a correction, or even a bear market, becomes high. One may come out the other side just as well by keeping current holdings.
However, the problem with doing so is that a 30% decline requires a 42% gain to get back to even, while a 50% decline requires a 100% gain to get back to even. That usually takes several years of the next bull market just to get back to even.
Taking profits and moving to cash when risk is high would seem to be a much better strategy, so that one keeps those profits and can immediately begin making additional profits when the correction or bear market ends, rather than needing the next few years just to get back to even.
Another approach, which I prefer, is that the best defense is often 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? 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.
ETF’s have become more widely available and popular since the 2000-2002 bear, and in the 2007-2009 bear market, while the S&P 500 lost 50% of its value, the ‘inverse’ ProShares Short S&P 500 ETF (NYSE: SH) gained 86%.
Even in last summer’s correction, while the S&P 500 lost 20% of its value, the inverse ETF SH gained 20%.
So investigate before investing, especially in Wall’s Street’s suggested ‘defensive’ holdings.