S&P 500: Defensive Rotation Signals Rising Downside Risk

With tech in trouble (+a number of macro risks lurking on the horizon), defensives are starting to look interesting…

Defensives (i.e. an equal-weighted basket of: Utilities, Healthcare, Consumer Staples) are turning up vs the S&P 500 —after going through what has been a major relative bear market.

But in particular, the following conditions make for a contrarian bullish (relative) setup for Defensives:

• Defensives’ relative value indicator reached similar levels to that seen at the peak of the dot com bubble (Defensives are extreme cheap vs the index).

• Investor allocations to defensives are ticking up from record lows.

• The market cap weight of defensives reached an all-time low late last year.

• The relative price (black line in the chart below) has seen an extended and extreme period of underperformance.

• And on the flipside, US (tech) stocks have likewise seen a number of extreme readings on sentiment, valuations, and allocations in the opposite direction (i.e. overall stock market downside risk is higher than we’ve seen since 2000 due to the key growth engine of tech stocks being overheated and looking somewhat burnt out lately).

Interestingly, this bullish outlook for defensive stocks is actually bearish for the stockmarket as a whole…

To be clear, when I say bullish outlook for defensives, I mean in relative terms — i.e. you expect defensive stocks to fall less or at best hold ground while the rest of the market falls more.

In this sense, defensives are interesting to keep tabs on both as a source of information on the market cycle (they fare relatively well in a downturn and lag behind in an upturn), but also as a sort of alternative hedge or portfolio risk dampener.

So seeing the defensives’ relative performance line ticking up from extreme lows (and the contrarian bullish setup for defensives I just outlined) tells us we need to pay closer attention to risk management and smart diversification right now.

Key point:  Defensives are looking good (that’s bad).

Bonus Chart 1 — Market Cap Weight

As noted above, defensives’ market cap weight reached an all-time low last year; since then, they have ticked up as tech has ticked down off record highs.

Again, this tells us about the state of the market cycle (note where previous extremes were, and how fleeting they ended up being — and how they ultimately resolved).

But it also tells us important investment strategy takeaways, such as how passive index investors are now heavily exposed to tech and on the contrary, also have historically low exposure to the diversifying and risk-dampening attributes of defensives.

So this is a timely prompt to consider both the big picture macro-market outlook, but also the pragmatic implications for portfolio strategy (e.g. is this the right sector mix for equity exposure? Should you look into smart diversification and up-weighting risk dampeners?)

Bonus Chart 2 — Earnings Weight

For completeness, here’s the earnings version of the market cap chart above, this one shows the earnings weight (or earnings % share) of each of those big 3 sector groups.

We can see that tech boasts the biggest earnings share, but also that cross-checking it against the chart above we can also see that the market has overshot.

Meanwhile, the history of defensives’ earnings weight tells us exactly why they are called defensives — because in times of turmoil and downturn, defensives’ earnings just keep plodding along and become a larger share of the index as tech and cyclicals ex-tech see earnings crunched by crisis, sector boom/bust cycles, and recessions.

So it pays to be cycle aware then think about equity exposure, stock market ups and downs, and overall asset allocation.

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