The Flight to Safety Could Burn You

Year to date, the S&P 500 is down 38%. Investment banks are no more, credit is still largely frozen, housing prices continue to drop, unemployment continues to rise, we're officially in a recession, and the Fed is promising extreme measures to try to turn things around.

What are investors doing? Continuing to flee. Stock mutual funds lost a net $72 billion in October, compared to a net loss of $56 billion in September. In fact, year to date, stock mutual funds have recorded a net loss of more than $195 billion -- compared to a net increase of $100 billion in 2007.

If there were ever a time for a defensive play, you'd think this would be it. And in fact, a lot of ink has been spilled this year touting the virtues of classic defensive stocks such as Eli Lilly (NYSE: LLY  ) , Pepsi (NYSE: PEP  ) , GlaxoSmithKline (NYSE: GSK  ) , and General Mills (NYSE: GIS  ) -- some of it on this website.

After all, the story goes, even when times are tough, people will still eat, they'll still heat their homes, and they'll still buy their medicines.

But if you've been putting your money in blue-chip consumer staples, pharmaceuticals, and utilities on the theory that it will be relatively safe there, you may want to think again.

First, it's not working
While defensive plays may have worked in previous downturns, they aren't working in this one. The collapse of the financial markets only intensified already-existing economic strains on the American family, including rising food prices, rising heating oil prices, rising foreclosure rates, and rising unemployment.

As the American family makes choices, old standbys have begun to find themselves on the chopping block.

For example, The Wall Street Journal reported that the number of prescriptions filled in the U.S. fell 0.5% year over year during the first quarter of the year -- and 1.97% during the second. That's the first time prescriptions have fallen in at least a decade. Furthermore, a survey by the National Association of Insurance Commissioners said that 22% of consumers are going to the doctor less often, because they just can't afford it.

Although increases in food prices have finally slowed, and gas prices have fallen drastically, rising unemployment and job insecurity are combining with a lack of access to credit to put significant economic pressure on the American family.

Those families don't think anything will change anytime soon: 62% of people surveyed in a Gallup poll think current economic conditions are "poor," and 82% think those conditions are getting worse.

All of this is having a negative effect on "defensive" stocks. Drug manufacturers are down 22% year to date, food manufacturing is down 29%, and grocery stocks are down 31%. Even utilities can't escape: Electric utilities are down 34%, and water utilities are down 31%.

While these sectors haven't lost you quite as much money as the market at large, there's still a clear trend: down, down, down.

That's been true of well-known individual stocks in those sectors as well. Merck is down 52% year to date, Winn-Dixie (NYSE: WINN  ) is down 12%, WellPoint (NYSE: WLP  ) has lost 54%, and CVS Caremark (NYSE: CVS  ) has lost 32%. Even Buffett favorite Coca-Cola is down 27%.

It turns out that when things get bad enough -- and a collapsed housing market, declared recession, a crumbling auto industry, and a shaky financial sector count as "bad enough" -- people do cut back, even on the essentials.

In other words, while a defensive play may cushion the blow, it really won't save your portfolio right now.

Second, it's a bad strategy
But even when macroeconomic factors don't conspire against the defensive play, it's still not a good strategy for your money.

Essentially, a defensive play is a "next hot sector" play -- only when times are tough, investors are merely content to find the "next not-as-bad sector" instead. But just as chasing hot performance will likely leave you empty-handed, investing in defensive plays when times are tough just because they're defensive plays will undermine your long-term returns. Why?

  1. It's historical, not forward-looking. The "next hot sector" is only apparent after it's warmed up -- and that means it's likely to cool down. Just ask anyone who was invested in tech stocks in early 2000; just because they were hot doesn't mean that popularity was sustainable. And just because so-called defensive stocks are in historically stable industries doesn't mean the companies or the industry in question won't be rocked by events no one saw coming. Remember, up until this year, nearly everyone thought financial stocks were defensive, too.
  2. It doesn't focus on the company. Even assuming an industry holds up against downward market pressure, an individual company isn't guaranteed to come out smelling like a rose. Conversely, just because a sector takes a nosedive doesn't mean a company will. Adobe Systems, for example, has returned 14% annually over the past 10 years -- bypassing the tech bust over the long term.

The Foolish bottom line
If you want to stay in stocks (and if you have money you won't need any time in the next five years, you should), where you should invest? Rather than trying to find stocks that won't lose very much in the turmoil, you should be looking for companies with excellent management, strong competitive advantages, excellent prospects, and strong balance sheets. Those businesses will outperform over time, even if the near term still looks stormy. Buying and holding is still the best choice for the majority of your portfolio -- especially when so many stocks are trading at unbelievable lows.

That's what we're doing at Motley Fool Pro, the new investing service we're soon reopening -- but that's not all we're doing. Fool co-founder David Gardner and his Motley Fool Pro team have invested $1 million of the Fool's own money in a portfolio designed to make money in any market.

The team, relying heavily on proprietary CAPS "community intelligence" data, is establishing long and short positions in a broad range of securities, including common stocks, publicly traded put and call options, and exchange-traded funds (ETFs). To learn more about Motley Fool Pro and to receive a private invitation to join when the service reopens in early January, simply enter your email address in the box below.

This article was originally published on Oct. 8, 2008. It has been updated.

At the time of publication, Julie Clarenbach had no stake in any company mentioned in this article. Coca-Cola and WellPoint are Motley Fool Inside Value selections. Eli Lilly and GlaxoSmithKline are Income Investor choices. The Motley Fool's disclosure policy plays offense, not defense.


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