market-downturn

As the end of the economic cycle approaches, many investors consider a rotation out of cyclical stocks, like industrials, and into defensive stocks, like healthcare and utilities. But do defensives really live up to their name?

In a market report, strategists for Dynamic Funds look at the performance of cyclicals versus defensives, and consider defensives from a risk standpoint.

Cyclicals tend to outperform when the economy is growing and underperform when it’s contracting. The report shows this by measuring relative performance of cyclicals versus defensives against the ISM Manufacturing index. The same relative performance plotted against the S&P 500 shows that defensives fare better when the broad index is faltering.

Read: Delivering on dividends

But relative performance is misleading when it comes to risk.

The report explains that the two most widely used metrics for classifying risk are correlation and standard deviation. Highly correlated assets aren’t desirable as they tend to drop in synch during a market downturn, and assets with higher standard deviations tend to have returns that fluctuate by a greater degree than assets with lower standard deviations. Neither metric is much help to investors when it comes to managing risk, “due to the fat-tail nature of stock returns, which are not appropriately captured by the normal distribution,” says the report.

Though consumer staples, healthcare and utilities have relatively low correlations with the S&P 500, as well as the lowest standard deviations, those two metrics go out the window during a sell-off—a time when no sector is immune to losses. During a sell-off, “capital preservation should be the main goal,” says the report, highlighting the importance of absolute versus relative returns.

The report goes on to look at sector drawdowns during two recent S&P 500 corrections—the tech bubble and the global financial crisis, when the index lost 46% and 53%, respectively.

During the tech bubble, investors focused on IT company losses during the 80% downward spiral. However, “fewer people remember that utilities, healthcare or staples quietly lost 56%, 33% and 18%, respectively, over the same time frame,” says the report.

During the financial crisis, those three defensive sectors fell by 41%, 40% and 30%, respectively. Though other sectors fell by more, “we do not know anyone that would brush aside losses of this magnitude,” says the report.

The bottom line is that absolute losses are real, so investors should look beyond relative performance when assessing risk.

Read: Finding a smoother ride for the cycle’s end

“We often see analysts and market experts suggest a rotation into defensive sectors on the fear of a looming market crash,” says the report. “However, history tells us that these defensive sectors will not save us during the severe corrections.”

Also read:

Hedge fund managers ready for market changes

Spring training for portfolios

Originally published on Advisor.ca
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