Defensive Stocks Ringing a False Alarm

 | Apr 26, 2013 | 12:00 PM EDT
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In financial circles, much ink has been spilled lately on the stock market leadership of the defensive groups.

Four of the 10 broad sectors within the S&P 500 index -- consumer staples, healthcare, utilities and telecommunications -- are usually considered defensive. These sectors are relatively steady, and they tend to hold up well during bear markets or corrections.

Year to date, among the 10 sectors, telecommunications (up 20%) and utilities (up 18.6%) are the two best performers. In the past 30 days, defensive groups have captured all three top slots, eking out moderate gains while most of the aggressive sectors, such as energy and materials, declined.

It's often said that the good performance by these "pillars of timidity" indicates trouble ahead for the market. That's a logical position, and there is some supporting evidence for it. But in this case it is probably a false warning signal.

The next time the market takes a tumble -- say, 5% to 10% down -- some pundits will be sure to say that the leadership of the defensive stocks was an alarm bell. The problem with this way of thinking is that declines of that magnitude occur about three times a year on average. So it's all too easy to declare that the indicator was right.

My own view is that the overall direction of the U.S. stock market for 2013 will be positive, and so it is worth riding out the corrections. I do not expect a major decline of 15% or more.

Another reason I wouldn't rush to buy defensive stocks is that most of them are expensive now, relative to their normal valuations. Among consumer staples stocks, the median price-to-earnings ratio is 22 (which it happens to be for Hormel Foods (HRL)). Among utilities, the median P/E ratio (for Pinnacle West (PNW)) is 17. And in healthcare, the median company (Becton Dickinson (BDX)) also has a P/E of 17.

I agree that defensive leadership shows that investors are nervous. But it does not necessarily show that they are right to be so. People's nerves were rubbed raw by the monstrous decline of October 2007 to March 2009 -- a peak-to-trough drop of 55%, even after taking dividends into account.

That 17-month bear market was so hideous that people have not gotten over it even now, four years later. Yes, the Dow and the S&P 500 have climbed back to their 2007 nominal peaks, and even a little above. But market psychology is still wounded.

There's an old saying that the market likes to rise with as few people on board as possible. I believe it applies in this case. If you are a medium-risk investor, I would stick primarily with the more aggressive names.

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