'Bear' in mind defensive stock reversals

Now, as the Wall Street party resumes in 2023, it is an ideal time to reconsider defensive strategies in their often overlooked context. While the returns generated by defensive stocks might not always match the returns of cyclical stocks during upward-trending markets, their added value should be considered within an overall portfolio context. Their strengths – reducing downside risk, curbing overall portfolio volatility, offering stable dividends, and diversifying portfolios – should not be underestimated.

Against this backdrop, we delve deeper into the concept of market overreaction, examining the subsequent five-year performance of defensive and cyclical stocks after their past five-year relative performance. Our research suggests that defensive stocks bounce back after a period of underperformance, allowing contrarian investors to benefit from cyclical overreaction patterns.

To understand this phenomenon, we divide the market into two parts: cyclical and defensive. We use a data-driven approach here because the cyclical/defensive classification on industries (GICS) is not useful for extended sample periods that go back more than 50 years. Assessing performance across market cycles from January 1929 to May 2023 reveals that defensive stocks are less volatile and have a lower risk profile than their cyclical counterparts.

While defensive stocks outperform cyclical ones throughout our comprehensive sample, this phenomenon is not consistent over time. Each category outperforms the other approximately half the time, and the shifts in performance can be stark and lengthy. The figure below shows the relative performance through time, with cycles defined by when the style reaches an all-time relative high. Performance cycles, characterized by at least a two-and-a-half-year span with a return difference exceeding 25%, typically last between three and ten years.

Defensive stocks outperformed cyclical ones in 51% of past five-year periods over our full sample period, with cyclical stocks leading in the remaining 49% – reflecting a broadly even split. Following a five-year period of strong performance for cyclical stocks, the subsequent five years usually favor defensive stocks. Moreover, defensive stocks have a positive alpha – measuring risk-adjusted returns – of 3.8% compared to a negative alpha of -3.6% for their cyclical peers. After a defensive rally, they continue to perform well but tend to slightly lag cyclical stocks by 1.3%. Overall, this environment is attractive for equity markets, whereas the alpha spread remains a healthy 5.0%. Similar outcomes for subsequent five-year returns are found when three-year and seven-year lookback periods are considered.

Following five-year strong returns from cyclical stocks, we find that equities have somewhat lower returns the next years. Thus the relative performance of low-risk equities might also be used as a market-timing indicator, although the five-year evaluation horizon may be too long for most investors.