Betting on Lower Bond Yields ?
Exhibit 2 shows that the relationship between bond yields and the relative price performance of defensive stocks has been particularly strong since 1990. Moreover, Exhibit 3 illustrates this relationship among two of the most widely perceived defensive S&P 500 sectors—consumer staples and health care. At least in the last two decades, a bet on defensive stocks has been a bet on lower bond yields. Is this a good bet today?
Exhibit 2
Exhibit 3
Even though the current 10-year bond yield is now below 3 percent, it could still move lower. It reached almost 2 percent in early 2009 and has declined steadily by more than 1 percent from its recent recovery high in early April. However, if bond yields continue to decline, although defensive stocks will likely outperform, the overall stock market will probably decline. That is, the best defensive stock investors may hope for is to simply "lose less" by outpacing a falling market.
During much of the 1 980s and 1 990s recoveries, defensive-stock performance was bolstered by a persistent decline in the 10-year bond yield within the context of a slow but steadily growing economy. Defensive stocks did well because their steady earnings profile compared favorably with more economically sensitive companies in a slow growing economy.
Today, however, if bond yields do continue to move lower, it won't likely be because the economy is growing slowly. Rather, lower yields from current levels will probably only result from intensifying double-dip recession fears (or even renewed deflationary abyss fears), in which case, defensive stocks may outperform but still decline in price with the overall stock market. So, while defensive stocks may be more popular than ever, do they make investment sense?
Defensive Stocks Risk-Reward Profile?!?
In our view, defensive stocks do not offer investors an attractive risk-reward profile. Investing in the 10-year Treasury yield will prove to be a winner if bond yields continue to decline and a loser if yields rise. However, investing in defensive stocks will prove to be a loser if bond yields rise (on a relative basis) and a loser if bond yields decline (on an absolute basis). This "lose-lose" risk-reward profile of economically defensive stocks may be unique to the post-war era. Normally, lower yields would be associated with a rising stock market in a sluggish economic recovery, but today, lower yields will most likely only be associated with rising Armageddon fears and lower stock prices (whether the stocks are economically defensive or not).
Investors should question whether defensive stocks offer the same potential and protection today as they have at similar times in past economic recoveries. Even if the future pace of growth in this economic recovery proves anemic, it may make more sense to invest less in the stock market rather than invest more in defensive sectors. Just food for thought as we begin the second half of the year!
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