Is now the time for loading up on defensive stocks?
After months of extraordinary quiet, stock market volatility returned in a big way in early February. The Dow Jones Industrial Average briefly found itself in correction territory, dropping more than 10% below its recent peak and effectively erasing its gains for the year. While the Dow has since clawed back some of those gains, it hasn’t exactly been a smooth ride. But that is the essence of volatility: The rises can be as sudden and unexpected as the gut-wrenching drops.
A closely watched measure of volatility expectations known as the “fear index” helps tell the tale. After hovering at historical lows for much of 2017, the Cboe Volatility Index® (VIX® Index®) rocketed upward in the first week of February and has since settled around its long-term average. That doesn’t mean expectations for volatility are low again. It’s just that they’ve returned to “normal” after a pretty long stretch of abnormal.
And with the Federal Reserve apparently intent on pushing interest rates higher this year, investors should probably expect more bumpy trading days in the months ahead.
So does that bolster the case for retreating to the relative safety of the so-called defensive stock sectors? Not necessarily.
Defensive sectors earned the name because they tend to do better than certain other sectors when the economy is slowing. The name can refer to the consumer staples, energy, health care, telecommunications and utilities sectors—all areas of the economy where spending tends to hold up even when things aren’t going well because they deal in necessities, like food and medicine, that consumers can’t do without.
You can contrast the defensive sectors with the more cyclical sectors such as consumer discretionary, financials, industrials and information technology. These sectors tend to do well when the economy is growing because consumers and businesses may be able to spend more on a new car, travel or productivity-enhancing investments.
How is the economy doing then? Pretty well, actually. In fact, the minutes from the last Federal Reserve (Fed) meeting suggest Fed officials are confident in the state of the economy. Growth is solid, employment is strong and inflation appears to be strengthening.
But that’s not the only reason to think now may not be the right time to load up on defensive stocks.
“Our friends at Ned Davis Research looked back at the last nine times the VIX spiked1 and found that in the month following, defensive sectors such as health care and consumer staples outperformed in seven of the cases, while utilities outperformed in six,” says Brad Sorensen, managing director of Market and Sector Analysis for the Schwab Center for Financial Research. “However, it didn’t last.”
“In the following nine months, more cyclical sectors were the best performers, with consumer discretionary outperforming in seven cases and technology outperforming in six,” he says. “Utilities did worst, outperforming in only two cases.”
All investors know that past performance is no guarantee of future results, but it’s worth keeping the past in mind given the current conditions, especially with the Fed planning to raise rates several times this year.
“The capital-intensive nature of the utilities and telecom sectors can make rate hikes painful from a business perspective,” Brad says. “Utilities have also been underperforming recently as people who had previously treated the sector’s high dividends as a bond substitute finally appear to be rotating out of the sector in favor of fixed income.”
Part of a diversified portfolio
If anything, the recent gyrations in the stock market have served as a reminder that the stock market and the economy aren’t the same thing. But they are obviously linked. With the economy growing and the bull market still running, we don’t see a strong case for taking an overly defensive stance.
Overall, we believe it’s important for investors to have some exposure to all 11 industrial sectors as part of an appropriately diversified portfolio. That includes an allocation to defensive sectors—even when the economy is still growing.
1Defined as times when the VIX rose above 35 after having been below 20 previously.
What you can do next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.