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The Best Offense is a Good Defense?

John McClenahan, CPA, CFA

While I still believe that economic conditions favor early cycle and secular growth stocks (see The More Things Change, the More They Stay the Same), what I find most interesting right now is the recent outperformance of defensive names over late cycle stocks, two areas of the market that normally travel together. The value of defensive stocks relative to late cycle stocks recently reached its highest level of the past five years.

5 Years Ended November 20, 2014

Past performance is no guarantee of future results. Sources: Morgan Stanley, Bloomberg LP.

As noted in my previous posts, the definitions of these two groups are:

Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. Defensive stocks tend to be in the consumer staples, health care, telecommunications, and utilities sectors.

Late stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and is now decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.

But what is the key difference between defensives and late stage cyclicals?

Roughly 60% of each group consists of consumer staples, utilities, and telecommunications. What’s different is that the defensive group includes 40% health care and the late cycle group includes 40% in energy and materials. So now it should be a little clearer what’s driving the divergence in returns. Since the recent market bottom on October 15, health care has rallied nearly 14%. Meanwhile, energy and materials have returned only 4%, with oil down -27% from its recent peak.

Will the divergence between defensives and late cyclicals grow larger or revert to the mean? It’s tough to say. I tend to think that neither of these areas will lead the market into early 2015. As I wrote in September, while we’re five years into a bull market, we haven’t seen a lasting decelerating trend in GDP or rising inflation—two signs of the late stage of the economic cycle. Until we see that happening, I don’t expect a sustained shift away from early cyclicals and secular growth. And defensives have rallied on fears over the spread of Ebola and the situation in Ukraine. While neither of these has gone away, the level of concern has diminished.

Regardless of what one thinks about these segments of the market, maintaining a balanced approach to portfolio construction—where relative exposures to secular growers, early cyclicals, late cyclicals, and defensives are not extreme—is a prudent path to successful risk-adjusted performance.

Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.

The price of equity securities may rise or fall because of changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time.

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