FMD Capital Management

Why You Should Rethink Your Defensive Game Plan

Written by David Fabian, May 02nd, 2013

With the market continuing to hit new highs on an almost daily basis, many savvy investors are starting to formulate their game plans to weather the next correction in stocks. Like a good game of craps, logic and probability tell us that eventually the dice are going to come up 7 and your chips go to the house. That is why it’s important to make sure that you place your bets in the right areas to stay ahead of the curve and emerge a winner.

The great rotation over the last 12 months has generally been in the areas of defensive stocks such as healthcare, utilities and consumer staples. Each of these sectors has enjoyed enormous demand and price appreciation that has benefited low volatility funds as well. However, in my opinion these stocks are over-loved and overbought which make them just as susceptible to cyclical sectors during the next correction.

Lets take a look at charts of the Healthcare Select Sector SPDR (XLV), Utilities Select Sector SPDR (XLU) and Consumer Staples Select Sector SPDR (XLP). Each of these ETFs have had a near vertical ascent over the year that is characteristic of a flight to quality in blue-chip companies with strong dividend yields.

The smart money has been benefiting from these asset flows and pushing prices higher which may make it hard to sustain a level of continued demand for these stocks. Markets typically turn when buyers become scarce. So if everyone already owns these sectors, who is left to buy at these levels?

Where to Hide Out

The next broad-based sell off could see a run for the exits as money managers rotate out of defensive stocks and back into Treasury bonds or other short duration fixed-income. I have previously mentioned the Vanguard Short Term Corporate Bond Fund (VCSH) as a potential safe haven in the event of a flight to quality. This fund holds a diversified basket of investment grade corporate bonds with an average duration of only 2.9 years.

In addition, if you are concerned about the effects of interest rate risk on your portfolio you might want to consider the iShares Floating Rate Note ETF (FLOT). This ETF invests in very short-term debt of financial companies whose coupon payments change based on the prevailing interest rate environment. Floating rate notes are widely considered to be an effective tool to combat rising interest rates.

These funds can both be used as short-term hiding spots for active investors who wish to preserve capital during periods of volatility.

The Final Word

While I still believe that defensive and low volatility sectors are an excellent long-term investment theme, I am not in love with them at these levels. I believe that investors will find better value by being patient and waiting for a pullback to enter these holdings. Once some of the excesses in the market have been worked off, you can start to build positions in XLP, XLU and XLV that have attractive income and capital appreciation potential.

If you already own defensive stocks and have benefited from their success, I would consider selling a portion of your holdings into strength to reduce your exposure to a correction. That way you still benefit if the uptrend continues, but don’t have the same level of risk in case these sectors start to unwind.

That is the game plan I am going to implement for my clients.