Are Defensive Stocks Really Safe?

05/19/2014 9:00 am EST

Focus: MARKETS

Wall Street's advice on how to prepare for possible market corrections has always been the same; no matter what happens to the economy, people will still have to eat, drink, and take their medicines, observes Sy Harding, market timing specialist and editor of Street Smart Report.

As a result, the expectation is that consumer staples, food, beverage, healthcare, and drug companies will do well even in economic and market downturns.

Also on the list are large solid companies with stable earnings, particularly those like utilities that pay solid dividends that should offset declines in their stock prices.

As one prominent brokerage firm posts on its Web site, “Defensive stocks represent necessary items, like food, gas, and medicine, and tend to change very little with the economic cycle because consumers are likely to continue buying them even in tough economic times.”

However, investors need to be aware that, while consumers will indeed have to continue to eat, drink, and take their medicines, and therefore continue to buy the products of those companies, in a market decline, investors do not have to continue to value the earnings of those companies as highly as during an exciting bull market. Furthermore, they do not.

In the enthusiasm of a bull market, investors may be willing to pay 20 times earnings for a stock, while, in the throes of a serious market decline, they will perhaps pay only 12 times earnings for the same stock.

Thus, although a company's earnings may continue to grow, even 'defensive' sector companies see their stocks decline in value in a market correction.

For instance, in the 2000-2002 bear market, these 'defensive' stocks plunged an average of 59% to their lows, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.

The utility sector was also highly recommended as portfolio protection, since utilities are noted for paying high dividends. However, the DJ Utilities Average plunged 60% in the 2000-2002 bear market, more than the S&P 500's 49% decline.

History seems to show that repositioning a portfolio into, so-called, defensive sector holdings when risk rises of a market correction do not provide much, if any, protection.

Currently, it's not surprising that, with rising concerns of a possible correction this summer, investors have been piling into the touted 'defensive' sectors to such a degree that they are significantly outperforming the market so far this year.

And, as long as the market holds up, they may be better than average holdings. However, history shows that investors preparing for a potential correction by piling into 'defensive' sectors, on the expectation that they will protect portfolios in downturns, are likely to be disappointed, to say the least.

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