Rip Up Playbook If You're Waiting for Market Correction
Let's ignore the fact that getting the timing exactly right to step out of the way of a big dip in the stock market is incredibly difficult and that attempting to do so obviously risks the opposite problem: missing out on further gains and then coming back into the market at the top.
Let's ignore all the contrarian instincts that tell us that with so many people worried about a correction there's no way a correction is in store in the near future.
Let's also ignore, for now, the fact that central bank-orchestrated rock-bottom bond yields, including trillions of dollars of debt trading at negative rates around the world, have thrown a gorilla-sized monkey wrench into all the best-laid plans to determine the fair value for stocks.
Instead, let's engage in the thought experiment of what will happen should this well-advertised correction in the stock market arrive as scheduled.
This is where things get interesting. Traditionally, in "correction" declines of 10 percent or more in the S&P 500, the safest place to be has been in "defensive" sectors -- like utility, telecommunications and consumer staples companies -- under the premise that consumers will keep things like electricity (and toilet paper) flowing even in the worst of times.
These are the sectors that typically lose the least while companies more correlated to the economic cycles (like financials, technology and industrials) are prone to the biggest declines in share prices, as Wells Fargo strategist Gina Martin Adams pointed out in a note on Monday.
However, despite a bit of a mini-rotation over the last month or so in which cyclical industries swung back in favor and defensives lagged, the leadership for 2016 -- and, in fact, for more than a year -- has been defensives.
If you rank the best-performing sectors that led the market higher after the S&P 500's record in May 2015, the scores are different but the leader board looks a lot like it should during a correction:
The reason for the outperformance of these groups is obvious to anyone who's set the foxhounds loose on the fabled hunt for yield: the relatively high and stable dividends that make many defensive industries attractive. This has pushed valuations -- especially for utilities and consumer staples -- toward the frothy end of the spectrum when compared with the overall market, which itself is at the frothy end of its own spectrum.
The question is how long this condition will last. While it may look like central banks have created a bubble in defensive industries, it's hard to know how much more air can be puffed into the bubble and what (and when) will be the pinprick that deflates it.
Still, if the great strategist Jimmy Cliff has taught us anything, it's that the harder they come, the harder they fall. So the old playbook -- hiding out in defensives if you're worried about a correction -- seems a little suspect at this point.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
To contact the author of this story: Michael P. Regan in New York at firstname.lastname@example.org.