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Defensive Tilt

Geopolitical tensions that include Russia/Ukraine and China/Taiwan debacles, trade wars, coupled with macroeconomic backdrops of higher interest rates, tightening monetary policy, and the potential for slower economic growth can lead to greater tail risk.

The strength in popular indexes last year (2021) masks the broader overall weakness in numerous sectors and stocks. Below the surface was significant churning and selling. In the S&P 500 Index, over 90% of stocks corrected at least 10% last year. The average SPX stock decline was 18%. In the technology-laden Nasdaq Composite Index, the average stock declined 40%, and nearly 90% of Nasdaq stocks witnessed at least 10% declines. In the small-cap markets, the Russell 2000 Index also averaged a loss of 36%, and an astounding 98% of RUT stocks endured 10% drops during the year.

As we move into 2022, not much has changed. Rising inflation continues. Interest rates are higher. Sector rotations and individual stocks continue to experience increased volatilities. Wall Street and Main Street USA are beginning to react to the above by decisively moving toward a defensive tilt.

Defensive, interest rate-sensitive, and commodities-related S&P sectors have led the market year-to-date basis. Energy (XLE) has gained 21.87% YTD, Financials XLF (-1.82%), Consumer Staples (XLP -2.96%), Utilities (XLU -9.15%), Industrial (XLI - 9.65%), and Materials (XLB -9.93%), and Healthcare (XLV -10.18%). The laggards on a year-to-date basis are Consumer Discretionary (XLY -17.38%), Communication Services (XLC -15.55%), Technology (XLK -15.31%), and Real Estate (XLRE -15.11%).

When defensive sectors lead the marketplace, at least from a relative basis, it can be an ominous sign of risk aversion or the economy and the stock market nearing a peak. Remember, defensive stocks tend to excel when the stock market is weak, but rarely do they relatively outperform their cyclical counterparts when the economy and stock market are strong.

Wall Street and Main Street may be concerned about the geopolitical events surrounding the Russia/Ukraine debacle but are more fearful of macroeconomic uncertainties such as inflation, Fed tightening, and the potential for another economic slowdown and recession.

In general, the stock market leads the economic cycle on an average of 1-2 quarters. Although one-and-two months performances do not make a market trend, outperformance from the defensive sectors against the economically sensitive sectors warns of the economy approaching full economic recovery.

As the business cycle shifts from the mid-cycle into late-recoveries, late-cycle economic sectors such as S&P Energy (XLE) and select Materials (XLB), defensive sectors such as S&P Consumer Staples (XLP), Healthcare (XLV), and Utilities (XLU), and interest rate-sensitive sectors like S&P Financials (XLF) begin to excel.

Our recent Relative Rotation Graph (RRG) study also reaffirms rotations into XLE, XLP, XLF, XLU, XLB, and XLV as these sectors dominate the Leading Quadrant. The Weakening and Lagging Quadrants include XLY, XLRE, and XLK. The Improving Quadrant only shows XLC and XLI.

Another SCTR large-cap screening study further shows the top 10 leading stocks ranked by SCTR score consist of Energy and Materials, including AA (SCTR score of 99.9), DVN (99.7), MRO (99.6), CVE (99.5), ICL (99.4), PBR (99.3), FANG (99.2), TECK (99.1), PBR/A (98.8), IMO (98.8). The next 10-stocks ranked by SCTR are also Energy and Materials names such as CNQ (98,7), EOG (98.6), CF (98.5), HAL (98.4), CTRA (98.3), PXD (98.1), COP (98.0), SU (97.9), EQNR (97.8), and OXY (97.7). It is astonishing to see the top 20 SCTR list comprised 16 Energy and 4 Materials stocks.

It is also interesting that before the 2000-2002 Tech/Telecom bubble and the 2007-2009 global financial crisis, the S&P Energy sector also relatively outperformed their S&P peers ahead of the two cyclical bear market declines.

Source: Chart courtesy of

Source: Chart courtesy of

Source: Chart courtesy of

Source: Chart courtesy of

Source: Chart courtesy of

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