Defensive Stocks Are Starting to Crack

The stock market saw big declines on Wednesday, wiping out Tuesday's gains and returning to close to their worst levels in more than a year. Inflationary pressures made themselves felt more prominently than ever in earnings reports from key companies, setting the stage for a decline that continued throughout the day. By the close, the Dow Jones Industrial Average (^DJI 0.67%), S&P 500 (^GSPC 0.87%), and Nasdaq Composite (^IXIC 1.11%) were down between 3.5% and 5%.

Data source: Yahoo! Finance.

Over the past six months, high-priced tech stocks with extremely strong growth prospects took the brunt of the damage. However, this week, we've seen some stocks that have historically been more defensive in nature start to take hits. That indicates that the bear market might be entering a new phase, and although it's impossible to be sure whether it will lead to a quick rebound or continue to drive indexes lower, it's bound to add to anxiety levels for many shareholders.

Playing defense

Investors have often looked to consumer-facing companies to weather economic storms in the past, especially those that have exposure to the staples that people actually need to buy on a regular basis. A conservative strategy emphasizing these stocks has done well during past downturns, and it had also been doing reasonably well in this one.

Image source: Getty Images.

However, this week's results from retailers Walmart (WMT 1.02%) and Target (TGT -0.71%) have changed the narrative on defensive consumer stocks. Even big-name retailers are facing problems due to inflation, with inventories building and supply chain disruptions causing difficulties across their businesses. Moreover, as consumers return to more normal behavior and even have to cut back due to higher prices, the big gains that many of these stocks enjoyed due to pandemic-boosted financial metrics are seeing abrupt reversals.

You can see this effect today even in stocks that didn't report their latest results. Elsewhere in retail, Costco Wholesale (COST 0.84%) fell 12%, as investors anticipate similar weakness in future reports. Among product manufacturers, Procter & Gamble (PG 1.52%) and PepsiCo (PEP 1.34%) were down 6%, while Coca-Cola (KO 0.63%) fell 7%.

Even the relatively defensive plays in the tech space took big hits. Apple (AAPL 0.51%) was down 6%, while Amazon.com (AMZN 1.49%) took a 7% hit. It really looked like conservative investors had nowhere to avoid the downturn in the market.

Low volatility?

The phenomenon was more visible in the exchange-traded fund (ETF) world. There, ETFs specifically designed to reduce volatility didn't work terribly well today. The Invesco S&P 500 Low Volatility ETF (SPLV 0.71%) is full of defensive stocks like Procter & Gamble, PepsiCo, and McDonald's (MCD 1.32%), but it was down 3.3% on Wednesday, just barely outperforming the 4% drop in the broader S&P 500. A similar fund, the iShares MSCI USA Minimum Volatility Factor ETF (USMV 0.46%), fell 3.7%.

Until today, those ETFs had been doing a reasonably good job. The Invesco fund was down just 5% in 2022 coming into the day, while the iShares fund was down 10%. That was notably better than the S&P 500's 14% decline.

Part of the problem is that investors have turned to defensive stocks so much that their valuations are often high. Costco trades at more than 30 times trailing earnings even after today's drop. Coca-Cola fetches more than 25 times earnings. Moreover, these aren't high-growth companies that are likely to produce outsized increases in bottom-line performance. They're mature businesses that will keep growing steadily, but only at a modest pace.

As Wall Street deals with ongoing investor concerns, keeping an eye on defensive areas of the market is important. If these stocks start to give up more ground than they have historically, it could bring about a new crisis of confidence among shareholders.