Forget everything you know about the markets: it’s all been turned on its head in the past month.
History has taught us that defensive areas of the market should outperform in an environment of high investor risk aversion, worries about slow growth and concerns about macro issues such as Fed policy and China’s economy. In turn, cyclicals and higher-beta sectors should be expected to lag sharply.
This time around, however, this longstanding relationship has been reversed: The safe havens have been taken out to the woodshed, while the highest-risk sectors have in fact outperformed.
Could this actually be good news for the market?
Where the Action Is … and Isn’t
From May 21 — the last day before Fed Chairman Ben Bernanke rocked the markets with his first utterance of the word “taper” — through the close Thursday, June 20, the S&P 500 Index has declined about 4.7%. During this same time, three of the “better” options have been sectors that are highly sensitive to the growth outlook:
|Consumer Discretionary SPDR||XLY||-4.4%|
Along this same line, small caps — as measured by iShares Russell 2000 Index Fund (IWM) — also have modestly outperformed with a return of -3.6%, thus far giving lie to the idea that smaller companies should fall faster when the market goes “risk off.”
On the opposite end of the spectrum are the areas of the market aren’t providing a shelter from the turmoil: namely, the safe haven plays. Utilities, telecommunications and consumer staples — the traditional defensive sectors — have all underperformed (or, fallen even worse than) the S&P since May 21. The Consumer Staples SPDR (XLP) has fallen 5.7%, a full percentage point worse than the broader market, while iShares Dow Jones U.S. Telecommunications Sector Index Fund (IYZ) has tumbled 8.4%, led by steep losses in Verizon (VZ) and AT&T (T). The Utilities SPDR (XLU) has been the worst of the bunch, losing 9.4%.
The underperformance in traditional defensives has had another effect that, unfortunately, has probably taken some conservative investors by surprise: the underperformance of low-volatility funds. Since the May 21 high, the PowerShares S&P 500 Low Volatility Portfolio (SPLV) — which holds just under half of its portfolio in utilities and consumer staples — has fallen nearly 7%.
It shouldn’t come as news that two other traditional refuges — bonds and gold — have both been taken out to the woodshed since the “taper” talk first hit the market. From the May 21 close through mid-day on June 20, an investor would have been better off owning U.S. stocks than either SPDR Gold Trust (GLD), down 7%, or a long-term bond portfolio such as Vanguard Long-Term Bond Index Fund (BLV), off 7.3%.
What Does This All Mean?
This leads to a question, and one for which the answer is difficult to discern since there is so little precedent for it: if the safe havens are in fact higher risk than the market itself, how long can the selloff continue? After all, the money needs some where to go. One alternative for those fleeing equities, of course, is cash. But, taper talk aside, short-term products continue to offer no yield — the same phenomenon that helped drive the multiyear rally in stocks in the first place. Stock market performance has been ugly, but the performance of the alternatives has been even worse.
In this environment, there’s a strong possibility that U.S. stocks’ role as “the best house in a bad neighborhood” may ultimately provide an important element of support in the months ahead.
This summer is shaping up to be a tough one, and volatility is likely to be off the charts. But if the recent upside-down nature of the market is any indication, this may prove to be an opportunity for nimble investors to buy the dip.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.