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The Flight to Safety Could Burn You

In the last year, the S&P 500 has lost 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. Investors took, net, over $200 billion out of stock mutual funds in 2008 -- compared to a net increase of $90 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 plays such as Abbott Labs (NYSE: ABT  ) , Kraft (NYSE: KFT  ) , Bristol-Meyers Squibb (NYSE: BMY  ) , and GlaxoSmithKline (NYSE: GSK  ) -- 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.

The American family is having to make choices -- and the old standbys are often 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 fell 1.97% during the second. It's the first time prescriptions have fallen in at least a decade. And that's not all: 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.

And those families don't think anything is going to change anytime soon: 75% of Americans believe we could have an economic depression in the next two years.

All of this is having a negative effect on "defensive" stocks. Drug manufacturers are down 21% in the last 12 months, food manufacturing is down 28%, and grocery stocks are down 26%. Even utilities aren't escaping: Electric utilities are down 33%, and water utilities are down 34%.

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.

And that's been true of well-known individual stocks in those sectors as well. Organic grocer Whole Foods (NYSE: WFMI  ) is down 72% in the last 12 months, Merck is down 47%, Tyson Foods (NYSE: TSN  ) is down 42%, and Reliant Energy (NYSE: RRI  ) is down 77%.

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

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

Second, it's a bad strategy
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 content to find the "next not-as-bad sector" instead of the next hot one. 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 it was hot doesn't mean it 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, financials were believed to be defensive stocks, too.
  2. It doesn't focus on the company. Even assuming an industry holds up against downward market pressure, it doesn't mean an individual company will come out smelling like a rose -- and just because a sector takes a nosedive doesn't mean a company will. Adobe Systems, for example, has returned 15% annually over the past 10 years -- bypassing the tech bust entirely.

The Foolish bottom line
So if you want to stay in stocks (and if you have money you don't need for 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 -- because those 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 that opened yesterday -- but that's not all we're doing. Fool co-founder David Gardner and his Motley Fool Pro team are investing $1 million 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, simply enter your email address in the box below.

Read/Post Comments (1) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 09, 2009, at 12:33 PM, stockgeek54321 wrote:

    I actually have a subsription to several of your services. I think you need to be careful not to give conflicting messages. On the one hand, you say investing in consumer staples and drug companies is not the way to go (that's the message I'm getting from todays article). On the other hand, you repeatedly show that the best performing stocks are precisely in the consumer staple/pharmaceutical area (Jeremy Siegals list). With an article like this, you are contradicting yourself.

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