Investors should consider starting out the year by playing defense.
Defensive sectors have historically outperformed benchmarks during periods of declining corporate profits, according to the latest paper from Richard Bernstein Advisors, an investment manager with $13.5 billion in assets. For example, within the S&P 500 index, health care stocks returned an average cumulative total return of 28 percent during each of the periods of decelerating earnings between September 1989 and 2020. Meanwhile, the S&P 500 index returned an average of 15 percent.
Other defensive sectors that surpassed the S&P 500 during periods of declining earnings include consumer staples (24 percent), utilities (23 percent), communications services (18 percent), and consumer discretionary (17 percent), according to RBA. (All returns are the average of the cumulative total return during each of the periods with decelerating profits.)
Amid market volatility in 2022, defensive stocks, most of which are dividend payers with stable earnings, had a good run. While they tend to underperform growth or cyclical stocks in bull markets, they are usually perceived as safer bets during recessionary periods. Dividend stocks gained 2 percent from January to October 2022, beating the market by more than 20 percent, Institutional Investor previously reported.
According to the RBA paper, investors have been primarily focused on interest rates during their equity valuation process in the past few months. But in 2023, declining profitability will become a more pronounced headwind. “An apparent limited fear of a potential profits recession suggests investors should start 2023 playing ‘defense,’” according to RBA. “Defensive sectors tend to outperform during profits downturns, and our portfolios are overweight those sectors.”
RBA also suggested that the potential profits recession should lead investors to look beyond the U.S. market. “Ten years ago, emerging markets were investors’ favorites, but global profit fundamentals signaled the potential for long-term U.S. outperformance,” according to the paper. “Today, consensus favors U.S. equities, but profit fundamentals for the U.S. are among the worst for major regions of the global equity markets.” European stocks, on the other hand, are least likely to surprise investors with negative earnings as of the third quarter of 2022, according to RBA.
By investing in defensive sectors, some investors might fear that they would miss out on the growth opportunities in the second half of 2023. But according to RBA, that shouldn’t be too much of a concern.
“If there is a fundamentally-based turn in the economy and in the stock market, such bull markets last for years and not for weeks or months,” according to RBA. “Missing out on the first month or two tends not to hurt long-term performance.