Defensive stocks are not the only ones that can outperform the market in a correction.
It might be tempting to think that all substantial market drawdowns look pretty much the same. Historically, in drawdowns of more than 10%, certain typically defensive segments tend to perform better than the market overall, and other typically cyclical segments tend to do worse. Materials- and energy-sector performance tend to be mixed and, in the case of energy, highly variable. But in the drawdown triggered by Russia’s recent invasion of Ukraine, materials and energy have been the strongest-performing sectors. In short: Not all drawdowns are alike.
In fact, energy stocks were the worst-performing sector during the March 2020 COVID drawdown, the end-of-2018 market selloff, and the Asia crisis in 1998; energy underperformed the overall market by 24%, 9%, and 6% in these drawdowns, respectively. However, so far this year the energy sector has outperformed the rest of the market by more than 15%. This sector also outperformed in the aftermath of the TMT bubble collapse in 2000 and 2001.
Figure 1 : Sector Performance During Equity-Market Corrections in the Past 25 Years
Three-Month Performance During Market Corrections of 10% or Larger
Energy stocks have become more attractive from both a risk and return perspective. We have seen the expected return on energy stocks increase and have also seen their average beta fall. This means that adding energy stocks to a portfolio improves that portfolio’s overall risk and return attributes.
We began to see an improvement in our estimates of energy stock returns in the second half of 2021, which were reflected in improved quality and sentiment measures. These themes continued in 2022, and they persisted through the drawdown that took shape earlier this year. Since the Russia-Ukraine war began, these trends have accelerated further.
Technology stocks have traveled the opposite risk and return path. Expected returns have dropped, and risk as measured by beta has increased, particularly in the software industry. Tech stocks have remained very expensive in our view, and sentiment measures — which declined precipitously over 2021 — have continued on the same trajectory during recent market events. The changes in the risk and return attributes for energy and technology stocks over the last three months are highlighted in Figure 2.
Figure 2 : Expected Risk and Return Attributes, by Segment
Looking through the risk/defensive lens, there are segments that we currently prefer, and segments that we currently don’t like, which are shown in Figure 3.
Figure 3 : Preferred and Least Preferred Defensive and Cyclical/High Risk Segments
The conventional wisdom that defensive segments consistently outperform and cyclical segments consistently falter during drawdowns is not correct. Typical defensive segments are not the only segments that outperform the market when there is a correction; not all defensive segments outperform, and not all risky segments underperform during drawdowns. We see attractive stocks in both defensive and cyclical segments of the market at this time.
The segments that we currently find attractive reflect market trends that have been evident for the last six to nine months. These trends have not reversed so far in 2022, despite global events that are roiling markets. In fact, the latest market correction has provided an opportunity to benefit from high-risk segments like energy. Even in the course of a deep drawdown, it’s important to remember that some trends are powerful enough to persist, even through extreme market conditions.
For use in EMEA: The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
Important Risk Information
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The views expressed are the views of Active Quantitative Equity through March 9, 2022, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
Quantitative investing assumes that future performance of a security relative to other securities may be predicted based on historical economic and financial factors, however, any errors in a model used might not be detected until the fund has sustained a loss or reduced performance related to such errors.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.