Defensive stocks lived up to their name again in 1Q 2016

It has been a challenging period for U.S. equity investors. The market has recently experienced two separate 10%+ drawdowns, one during the second half of 2015, and the more recent during the first six weeks of this year. In both instances, the market recovered in fairly short order to return to pre-correction levels. The reward for all this volatility has been relatively meager as the S&P 500® Index returned just 2.8% for the fifteen months covering January 1, 2015 to March 31, 2016. This is noticeably less than the 15.3% average return experienced for similar 15 month stretches going back to 1970. 2015 vs. 2016 Q1: Déjà vu all over again Represented by the S&P 500® Index. Morningstar.
Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. For investors finding such market gyrations unnerving, the prospective horizon may prove trying. Relatively high valuations and soft corporate profits help establish expectations for U.S. equity returns towards the lower end of historical ranges. Combine modest expectations with political and central bank uncertainty and it’s not hard to imagine continued market volatility. Lower returns with higher volatility are not what most investors are seeking from the equity portion of the portfolio. It’s impossible to influence future market outcomes, but there may be opportunities for improving relative portfolio outcomes. One strategy that holds potential for choppy market conditions is the incorporation of defensive stocks within a multi-asset portfolio. Defensive stocks should not to be confused with low volatility stocks – although they do tend have lower volatility by their nature: defensive stocks represent high quality companies that tend to outperform other segments during difficult market environments. A review of the performance of the Russell Defensive Index over the last 15 months supports this belief: Defensive stocks live up to their name TWO 10 PERCENT PULLBACKS IN LESS THAN ONE YEAR Stocks: S&P 500® Index, Defensive stocks: Russell 1000® Defensive Index, Source: Morningstar. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly During this difficult period for the U.S. equity market, not only did the Russell 1000® Defensive Index top the return of the S&P 500 Index – 6.3% vs. 2.8%, respectively – for these fifteen months, but it also delivered a lower level of volatility – 12.4% vs. 13.9%, respectively, as seen by these standard deviation numbers. To many investors, that’s an appealing combination. This dynamic is observable in other past periods, too. Looking back at the 30 years ending March 2016, defensive stocks have routinely topped the broad market, plus growth and value stocks, during periods of lower than average returns and periods of higher than average volatility (rolling 12-month periods). Average One-Year Returns, April 1986 - March 2016 Sources: Defensive Stocks: Russell 1000® Defensive Index, Growth Stocks: Russell 1000® Growth Index, Value Stocks: Russell 1000® Value Index; One-Year: Rolling 12-Month Periods of which there were 349 between 4/1986 and 3/2016. Defensive stocks have historically delivered this type of performance because of their dual defining factors of quality and low volatility. Russell Investments views the following criteria as being essential to classify a stock in the defensive category:
  • Low balance sheet leverage (measured by ratios such as debt-to-equity)
  • Low earnings cyclicality (variability of earnings)
  • Strong business model (measured by ratios such as Return on Assets (ROA))
  • Low price volatility relative to the average stock over the last one to five years
Stocks of companies that have low leverage, low earnings variability and strong ROAs are commonly referred to as “quality stocks.” When these quality factors are combined with comparatively lower stock price volatility, an attractive long-term performance pattern typically emerges. Investors appreciate it all the more during periods of market stress.

The bottom line

Over the past nine months, the U.S. stock market has experienced a stretch of higher volatility. The increase in risk was accompanied by below average returns. Such conditions may tempt many investors to reduce their equity exposures. What may help is an equity strategy that has shown the ability to perform in comparable market environments. Defensive stocks have accomplished this feat in the past and are likely to in the future again. It may be time to consider defensive stocks for a role in client portfolios.