Still Bullish, but Growing Defensive

06/24/2013 9:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

Although indicators continue to confirm the bullish trend, Jim Stack of InvesTech Research says the summer markets call for a more defensive stance.

The market may be overdue for a correction, but technical and fundamental data remain positive—supporting our current 89% invested allocation target. Bear-market warning flags that would warrant a more defensive stance are not evident at this time.

There is no sign of divergences in market breadth or bellwethers, and we are encouraged by the continued improvement in the Leading Economic Index and in consumer confidence.

The overall invested allocation target must be based on this evidence, and not on the likelihood of a correction. It is not advisable to reduce investments simply based on the fact that we are in the midst of a six-month "correctionless" bull-market run.

However, given the higher probability of a correction—and especially as we enter the seasonally soft summer time frame—we should review sector allocation to ensure portfolios are positioned to weather any downturn while still capturing further market appreciation.

During previous corrections in this bull market, it is perhaps not surprising that the more defensive sectors held up better than the market. This bull market, which began in March 2009, has experienced ten corrections of 5% or more. In each, the Consumer Staples and Health Care sectors outperformed the S&P 500-a 100% batting average.

Telecom and Utilities have also performed better than the index on average, with Telecom gaining more than the index in nine of the ten pullbacks of this bull market, while Utilities has outperformed the S&P 500 in seven of the last ten corrections.

All four of these defensive sectors generally reduced losses to about half of the broader market, with average declines of 5% or less vs. -9.1% for the S&P 500.

Consumer Discretionary and Technology have performed about in line with the market during corrections, losing on average between -8.7% and -9.2%, respectively, and they beat the Index just about half of the time. The batting average for Consumer Discretionary is 60%, slightly better than 40% for Technology.

Consistent underperformers during corrections include more cyclical sectors: Industrials, Energy, Materials, and Financials. Each proved more resilient than the Index only once during the past ten corrections, and on average showed double-digit declines.

Clearly, if odds favor a correction as they do today, having a defensive sector focus is warranted. Sector seasonality studies also suggest a defensive sector focus may be prudent.

It is well known that the market experiences seasonal tendencies, with the majority of gains being realized in the winter period (November to April) as opposed to the summer months (May to October). This phenomenon is often referred to as "Sell in May and go away."

While we don't subscribe to that investment strategy because summers still generally show a gain, it does make sense to be more defensively positioned during these months.

Top performance in the more favorable winter months is dominated by cyclical sectors. Leaders include Consumer Discretionary, Materials, and Industrials, each gaining nearly 10% or more vs. a 7.2% increase for the S&P 500. Technology, Energy, and Financials also perform better than the market on average in the winter, but by a smaller margin.

The most defensive sectors—Health Care, Consumer Staples, Utilities, and Telecom—have been the worst performing areas in the November to April time frame.

Sector leadership has historically experienced a dramatic shift in the summer months. The defensive Consumer Staples and Health Care sectors move to the top of the list in the summer, with gains exceeding 4% on average, compared to slightly less than 1% for the S&P 500.

And Consumer Discretionary, Industrials, and Materials become the laggards in the summer. In fact, these are the only three sectors to average a decline in either the summer or winter months. Energy and Technology show less seasonal tendencies, slightly besting the market during both periods.

Given this seasonality trend, coupled with the data shown above for sector performance during corrections, it appears the safety-first decision is to overweight defensive areas of the market at this time.

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