Defensive stocks: When to change the course of your portfolio

When to load up on defensive stocks

Timing the market is difficult; instead, focus on your own asset allocation and risk tolerance

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Q: Is it reasonable or practical to shift to defensive stocks and mutual funds to prepare for a market recession?

Financial people all say not to try market timing.

—Hal

A: Global stock markets had a strong year in 2017, with all the major indices posting gains over the past year. While Canada’s Toronto Stock Exchange (TSX) is near an all-time high, Hal, it’s worth noting it is only marginally higher than the summer 2008 peak prior to the financial crisis. It hasn’t been a great 10-year run for Canadian stocks.

Recessions are part of the natural economic cycle and occur when there is a decline in economic growth for two consecutive quarters (6 months). There have been 13 recessions in Canada over the past 100 years. The duration tends to be 3-9 months. Canada’s recessions also tend to coincide with U.S. recessions.

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Stock markets are “leading indicators”, with stocks generally falling in advance of a recession. This is because stocks trade based on an anticipation of where things will be in, say, 6 months. On that basis, by the time recession hits and you read the headlines, you’re probably too late to time the markets.

Based on several measures, stock markets are getting expensive, particularly in the U.S. Stocks have moved higher over the past 8 1/2 years since the financial crisis ended in the first half of 2009. I can see why you might be worried, Hal, that stock market growth may be getting a little long in the tooth.

Stocks that tend to do well late in the business cycle are inflation-sensitive and defensive stocks like materials, energy, health care, utilities, consumer staples and telecoms. Timing the markets is notoriously difficult though. Technology tends to do well mid-cycle, but it has been the sector driving most of the growth of U.S. stock markets in the past year, nearly doubling the next best sector on the S&P 500 in 2017.

Although you mention that financial people all say not to try market timing, Hal, I would disagree with that statement. I find most financial people do try to time the market, whether economists for banks, active mutual fund or pension managers, or most investment advisors. That doesn’t necessarily mean you should try to time things though. Many of the professionals trying to time the market do a poor job, despite any assertions to the contrary.

Whether or not you should shift your investments depends on many factors. I think you should always begin with risk tolerance and at any given time, if your investments are riskier than your risk tolerance suggests they should be, you should become more defensive. Some investors who have not maintained their asset allocation as stocks have moved higher may be invested more aggressively than they should be right now.

Beyond your risk tolerance, Hal, consider when you need money and from which of your accounts. If you have money invested that you need in the next five years, you should consider reducing your allocation to stocks and becoming more defensive regardless of the point in the business cycle. A global balanced portfolio is unlikely to deliver a negative return over a five-year period, but over a shorter period, especially at this point in the market cycle, it’s certainly possible.

Bonds may be generating paltry returns these days, but they have a place in a portfolio. If stocks fall, bonds are defensive and may insulate your portfolio from losses. So, when you’re considering whether you should be more defensive, you should also consider whether defensive means defensive stocks or whether it should include fixed income. And when you’re considering market timing, remember that it’s tough to do, even for the so-called professionals.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.

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