Defensive stocks typically perform in choppy markets

This year has gotten off to a bumpy start for many investors. Equity markets1 dropped quickly in early January and have seemed to hover in the range of down -5% to -10% ever since. While there is still the possibility of additional drops, the more likely remnant from the beginning of the year is higher volatility. Over the past few years, the U.S. equity markets (and investors!) enjoyed above average returns at lower than typical levels of volatility. This relationship can’t continue forever, and many believe the beginning of 2016 reflects the changing conditions. When market volatility does pick up, investors often seek ways to mitigate some of that additional risk. A potential solution is the inclusion of defensive stocks within the portfolio. They have historically tended to hold up better – in terms of return and volatility – than broader equities during choppy market conditions. Incorporating such stocks can help investors weather rough markets while at the same time allowing them to maintain the equity exposure they need in order to meet long-term financial goals. The anatomy of a defensive stock Defensive stocks reflect many of the following traits:
  • Low balance sheet leverage (which can be gauged by the firm’s debt-to-equity ratio)
  • Low earnings cyclicality
  • Strong business model (which can be measured by ratios such as Return on Assets (ROA))
  • Low price volatility relative to the average stock for 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 return pattern has typically emerged during periods of stock market volatility.

Defense stocks through time

Looking back at the last thirty years of data for market indexes, the numbers support this statement. Since 1986, defensive stocks2 have outperformed the broader equity market3, as well as value4 and growthstocks, during one-year periods of higher than average market volatility. One year annualized returns Sources: Russell 1000 Index, Russell 1000 Value Index, Russell 1000 Growth Index, Russell 1000 Defensive Index. Average market volatility in the period 1986-2015 was 13.5% as measured by standard deviation. 163 12-month rolling time periods are reflected in this chart. Rolling returns are useful for understanding the behavior of returns over multiple time periods. For example, 5 year time periods calculated monthly over 10 years allows us to view 61 observations as opposed to looking at a single end date. This helps to demonstrate patterns or longer term trends in the data. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Defensive stocks have shone even more during periods where higher than average market volatility was coupled with lower than average market returns. In those cases, the one-year returns of defensive stocks6 topped those of the broader market,7 value stocks8 and growth stocks.9 One year annualized returns higher than average market volatility and lower than average market returns Sources: Russell 1000 Index, Russell 1000 Value Index, Russell 1000 Growth Index, Russell 1000 Defensive Index. The average return for the period 1986-2015 was 12.0%. The average market volatility during that same time period was 13.5% as measured by standard deviation. 88 12-month rolling time periods are reflected in this chart. Rolling returns are useful for understanding the behavior of returns over multiple time periods. For example, 5 year time periods calculated monthly over 10 years allows us to view 61 observations as opposed to looking at a single end date. This helps to demonstrate patterns or longer term trends in the data. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. What’s more, defensive stocks10 have achieved the return resiliency with less volatility than the broader equity market.11 This is especially evident during periods when the market’s volatility has spiked during periods such as the post-Tech Bubble crash and the Great Financial Crisis. Rolling 3-Year Standard Deviation chart Sources: Russell 1000 Index, Russell 1000 Defensive Index. 325 36-month rolling return periods are reflected in this chart. Rolling returns are useful for understanding the behavior of returns over multiple time periods. For example, 5 year time periods calculated monthly over 10 years allows us to view 61 observations as opposed to looking at a single end date. This helps to demonstrate patterns or longer term trends in the data.

The bottom line

Investors concerned about the outlook for U.S. equities, especially with the potential for increased volatility, may want to consider a role for defensive stocks within their portfolio. The emphasis on higher quality, lower volatility stocks has the potential to provide the foundation for competitive returns in unsettled market environments. In turn, investors may gain the confidence necessary to maintain equity exposure through difficult market conditions.
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