There are plenty of reasons to pursue a more defensive equity strategy, but paradoxically enough, this also carries several risks.
The worldwide stock market rally, which started in 2009 and set a new record last August as the longest ever, has certainly not been characterized by euphoria, with the 2011 Eurozone debt crisis, the Fed's unexpected announcement of plans to phase out quantitative easing in 2013 (the 'taper tantrum’) and the unanticipated devaluation of the yuan in 2015.
More recently, we had the very recent sharp drop in the market in October 2018 brought about by a complex combination of factors: a fear of protectionism, rising interest rates, declining economic and earnings growth, and geopolitical quarrels. In short, unlike what we saw during the dot-com rally of the late 1990s, market sentiment has been far from festive − in fact, investors have had to climb a wall of worry.
In the period following the financial crisis, when the global economy struggled to recover, stocks of companies that still managed to offer solid earnings prospects proved to be very popular. In the last few years in particular we've indeed seen growth stocks deliver spectacular performance relative to value stocks.
Growth sectors include information technology, consumer discretionary, materials and industrials. The graph above shows that these sectors have outperformed their defensive counterparts by 40% since the start of this bull market in 2009. Consumer staples, telecom, health care and utilities are examples of defensive sectors.
More recently, however, there has been a noticeable decline in the performance of cyclical stocks relative to defensive growth stocks: in March of this year, cyclical stocks were still outperforming defensive stocks by 53%. Does this mean, on closer consideration, that the cyclical stock rally is already past its peak?
There are several reasons why next year it might be wise for investors to position themselves for a more defensive approach to equity investing.
Now that we’re in a late phase of the economic expansion, climbing the wall of worry seems to be getting increasingly difficult for the stock market; economic growth is at a turning point where acceleration will give way to stabilization and eventually, to deceleration. With economic growth diverging, there is now nothing left of the widespread economic growth spurt observed by economists in 2017.
An environment of disappointing growth is usually bad news for growth stocks and goes some way to explaining why defensive stocks may gain further ground. The apprehension of the market amid rapidly rising interest rates is also a factor. Growth stocks typically deliver the expected profits later in the game than more defensive stocks, which already generate a continuous (and usually more steady) cash flow.
The fact that future cash flows have a longer duration means that growth stocks are more sensitive to an environment of rising interest rates. For next year, too, we predict a further rise in long-term interest rates. We also see that valuations in several cyclical sectors are much higher than in defensive sectors.
This higher valuation increases the downside risk of cyclical stocks in the long run, particularly in a market that is more volatile overall, as we expect to be the case in 2019. Amid greater market volatility, it may also be worthwhile to pursue a defensive strategy with increased exposure to value stocks, low-risk stocks and/or high dividend stocks.
Shifting to a more defensive profile also has risks. Positive economic growth surprises, central banks (including the Fed) hiking policy rates more gradually and/or diminishing geopolitical risks (e.g. Italy and Brexit) may in fact breathe new life into growth stocks.
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