When the stock market starts heading south, lots of investors run for cover. But if you already have the right stocks in your portfolio, you may actually benefit from a market downturn -- or at the very least, your investments will hold up better than those who fail to heed the warning signs.
A change in sentiment?
For almost a year now, the best thing you could do with your money was to choose aggressive, high-risk stocks. Despite almost constant skepticism from those who focused solely on economic fundamentals, many stocks not only failed to collapse, but also posted amazing returns in the process.
Unfortunately, all bull runs must eventually come to an end. When that happens, you can no longer rely on a rising market to push your entire portfolio upward. Instead, you need to pay attention to stocks in industries that can perform well no matter what the overall market is doing. Fortunately, you have several promising sectors that fit the bill right now.
Fleeing from correlation
If you're a conservative investor, the key to a successful investment is one that won't behave the same way as other investments you already own. If everything you own goes up or down at exactly the same time, then being diversified does you no good -- you're still exposed to the full risk of the market. However, if you can find investments that will go up -- or even just go down less dramatically -- when the broad market is falling, adding them to your portfolio can protect you from market downdrafts and give you a much smoother ride over the long run.
In searching for such investments, I looked at various market sectors to see how they correlated with the overall market. Here's what I found:
|
Sector |
Correlation to S&P 500 |
|
|---|---|---|
|
Utilities |
0.61 |
48% |
|
Energy |
0.92 |
50% |
|
Health Care |
0.71 |
66% |
|
Consumer Staples |
0.58 |
76% |
|
Financials |
1.60 |
77% |
|
Technology |
1.05 |
83% |
|
Consumer Discretionary |
1.13 |
83% |
|
Materials |
1.26 |
85% |
|
Industrials |
1.21 |
91% |
Source: Morningstar.
Looking at the data, which encompasses the past three years of market movements, the results aren't entirely what you might expect. Let's take a closer look:
- Topping the list are utilities like Exelon
(NYSE:EXC) and Southern Company(NYSE:SO) . Utilities have a reputation as being appropriate for conservative investors, so it's no shock to see that they move with less volatility than the overall market. Often associated with strong cash flow and healthy dividends, utilities may be the answer to low yields on bonds and other fixed-income investments. - Stocks in the health-care and consumer-staples sectors are also considered downturn-proof. Companies like Pfizer
(NYSE:PFE) and Merck(NYSE:MRK) have millions of customers who rely on their products in order to survive and stay healthy. Similarly, the companies that make everyday necessities for consumers, such as Procter & Gamble(NYSE:PG) and Colgate-Palmolive(NYSE:CL) , are among the last to suffer even when times are tough. - The surprising entry on this list is the energy sector. Stocks like Chevron
(NYSE:CVX) are highly correlated with oil prices, which tend to move fairly closely with the strength of the economy. Over the past three years, though, you've seen huge price movements in oil and natural gas -- movements that weren't always in lockstep with how the stock market performed. That goes a long way toward explaining why the sector's correlation with the S&P is so low.
Of these sectors, I'd argue that utilities are the most promising right now. A focus on green energy could revolutionize the utility industry, and companies that get in on the ground floor could take advantage of potentially huge incentives to ramp up transmission infrastructure and generating capacity. How utilities and energy companies split up responsibility in this regard could be the key to determining which sector enjoys better growth in the years to come.
Traditional defensive plays like health care and consumer staples certainly have their benefits. But with health-care stocks in limbo over potential future regulation, they face an unusual type of risk right now.
Don't go broke
It's true that those who've been willing to take risk in the past year have been richly rewarded. But if you're ready to ease up on the throttle, defensive stocks can help you ride out a downturn without losing all your hard-fought gains.
Dividends give you a cushion against bad markets. Todd Wenning can show you the best dividend stocks of the decade.
