With the government’s last-minute deal last week to raise the debt ceiling and end the shutdown, the United States avoided the worst case-scenario of a default, at least, that is, for now. The temporary deal means that policy uncertainty remains and we may find ourselves back on the brink of default in a few months.
It’s no wonder, then, that many investors continue to allocate to so-called “defensive” investments. However, as I write in the new Market Perspectives paper I co-authored with Daniel Morillo, “Understanding Defensive Stocks and Their Tradeoffs,” not all defensives are created equal in all market scenarios. This is why, before going defensive, it’s important for investors to consider these three aspects of their potential defensive postures:
What they’re trying to defend against. In allocating to defensive stocks, investors will want to be precise and differentiate between different types of risk. Investors who are trying to defend against a market correction¸ for instance, would probably want to think about investments that fit the traditional concept of a defensive stock, i.e. low beta stocks whose value should theoretically go down less when the market corrects.
However, there are other ways to define defensive. Rather than focusing on beta, investors often look for companies that are less dependent upon economic growth. Finally, other investors may want to defend themselves from a particular event, like rising rates. The key point is that what you want to own is largely a function of what you’re trying to defend against. The optimal balance to insulate a portfolio from a market correction may be different than the basket used to guard against rising interest rates.
At the same time, it’s also important to recognize that when trying to defend against one scenario, investors may be exposing themselves to another. Case in point: Many of the traditionally defensive stock sectors, like utilities and consumer staples, tend to be rate sensitive. So while they may help protect a portfolio from certain market corrections or a weak economy, they may not be as effective when a market correction is caused by a rising rate environment, as was the case this past summer.
How has a company or sector changed over time? It’s also important to recognize that even which stocks fit the traditional definition of “defensive” changes over time. For example, while healthcare stocks are viewed as more defensive today, they were significantly more sensitive to economic and market conditions 15 years ago and their sensitivity may change again with the new healthcare law. Similarly, the technology sector used to be the antithesis of defensive back in the 2000s, but since then, many of the surviving technology stocks have become large, reasonably stable businesses. As a result, the sector is less sensitive now to the market than it has been in the past. Meanwhile, in contrast, the financials sector has moved in the opposite direction and may move again amid increasing regulations. The key point here is that exactly how defensive a stock is, and even whether it’s defensive in the first place, actually changes over time.
The cost of the defensive strategy. Finally, it’s important not to overpay while seeking safety. Insurance is a wonderful thing, but if the cost of the premium is too high, you may be better off accepting the risk. Today, some of the defensive sectors, such as utilities and consumer staples, are expensive, meaning you may be paying a very large premium to get only short-term risk mitigation. In my opinion, this may not be worth it. In a similar way, investors often overpay for a hedge. This is particularly risky at a time when unconventional monetary policy is still distorting pricing in many asset classes.
In short, defensive companies and sectors play a vital role in a portfolio. That said, defensive companies are not a free lunch.
Source: Market Perspectives, “Understanding Defensive Stocks and Their Tradeoffs”.