Stocks have been on a nice run, but the next market correction may not be far off. When it happens, you’ll want to own these four defensive ETFs.
You’re probably familiar with the old Wall Street adage that says “bull markets climb a wall of worry.” This bromide was certainly proven after the U.S. stock market bottomed in March 2020. But as long as the market’s technical backdrop remains strong, bull markets continue to feed off this worry (which typically creates a rapid pile-up in short interest that can quickly ignite short-covering rallies) and defensive ETFs will continue to be promising investments.
But what happens when the market’s internal condition eventually begins to weaken and those widespread worries show no sign of diminishing? This was precisely the condition that precipitated the February/March 2020 sell-off in the major averages, as investors’ fears over the spreading coronavirus served to fuel the selling pressure. Today, we’ll discuss the double-edged sword of worry as it pertains to the stock market and how you can hedge your portfolio against another fear-driven market decline.
When the bulls of Wall Street command the field, it’s too early to think about selling stocks. But it’s never too early to prepare a strategy to protect your portfolio from the next market correction, and you can do that with defensive ETFs.
One of my favorite indicators for gauging the internal strength or weakness of the broad market is the number of stocks making new 52-week highs and lows. The new highs-lows reflect the incremental demand for equities, and in a healthy market environment, there should be fewer than 40 stocks making new 52-week lows on a daily basis. New 52-week highs, by contrast, should ideally outnumber new lows by a ratio of 3:1 or greater.
Once new lows rise above 40 for several consecutive days, you’ll know it’s time to begin “pulling in the horns” by trimming laggards from your portfolio, raising protective stops on existing long positions, and looking at potentially attractive defensive stocks and defensive ETFs to rotate into.
The danger of a market in which new 52-week lows are above 40 (and rising) is that stocks, in general, become far more vulnerable to negative headlines and worries. While stocks typically ignore bad news and feed on fear during a strong market environment, in a market characterized by internal weakness, investors’ fears can become self-fulfilling as selling begets more selling (with no one interested in buying the dips).
Fear, then, is a double-edged sword that can be beneficial for stocks in an internally strong environment, but detrimental to stocks when the market’s backdrop is technically weak.
When the new 52-week lows are steadily increasing, fear is most likely to drive stock prices lower. Fortunately, we’re in good shape at the moment after a strong week from the market: only 18 NYSE stocks are at 52-week lows as of this writing.
4 Defensive ETF Sectors for a Fear-Driven Market
As we saw from growth stocks in recent months, that momentum can come to a screeching halt in a hurry. One of the first things you should do when the market starts showing signs of internal weakness is to look for areas of the market which were ignored during the rally phase. Underachieving sectors and industry groups often (though not always) become the new leaders once a market correction has ended as institutional investors typically seek out-of-favor stocks to rotate into. And if these ignored sectors happen to be defensive in nature, it increases the odds that such stocks will rally during—or immediately after—a market downturn.
One such group that has been largely ignored during the latest phase of the bull market is utilities.
Defensive ETF Sector #1: Utilities
Utility stocks have a long-established history of being among the most defensive stocks since we all need water, gas, and electricity regardless of the business climate (even in a recession). Utility companies have the added attraction of benefiting from the lower interest rates that are prevalent right now.
I expect that utility stocks will begin outperforming the major averages once we’ve entered another down phase in the market. One way to have exposure to the utilities without the heightened volatility risk of individual stock ownership is through the Utilities Select Sector SPDR ETF (XLU). This ETF also pays a dividend.
Defensive ETF Sector #2: Consumer Staples
Another traditionally defensive area of the market is consumer staples. Consumer staples have also underperformed in this new bull market, though they typically perform well in a recession; after all, people will always need to buy things like shampoo, toothpaste and toilet paper. The staples also tend to outperform when high-flying leaders—like the big tech names—come under selling pressure, as they have lately. For that reason, I recommend keeping an eye on the Consumer Staples Select Sector SPDR Fund (XLP). The fact that consumer staple stocks have recently shown signs of life could mean that the “smart money” is rotating into this overlooked segment.
Defensive ETF Sector #3: Gold Stocks
Another way to benefit from a fear-driven market is to watch the asset class that has always historically served as a hedge against a weak stock market. I’m referring, of course, to gold, which typically benefits when worries abound. Accordingly, gold is one of the ultimate safe haven assets which investors should consider owning in a fear-driven market.
While it’s commonly believed that gold always trades inversely to the stock market, that hasn’t been the case in recent years as both gold and equities have simultaneously risen for extended periods. The reason for gold’s persistent strength is plainly evident in the daily news headlines. There are also lots of geopolitical risks and worries over the strength of the global economy. With such worries abounding, gold should have a built-in psychological support for months to come.
One of the best ways to own gold is through a low-priced ETF like the iShares Gold Trust (IAU).
Defensive ETF Sector #4: U.S. Treasury Securities
A final consideration for a fear-driven market is U.S. Treasury securities, which are normally in high demand during periods of heightened stock market volatility. One of the best ETFs to own during such periods is the Vanguard Extended Duration ETF (EDV). This ETF tracks the performance of zero-coupon extended duration Treasury securities, thus providing exposure to the strong Treasury bond market. T-bonds have benefited from safety-related demand in recent years, and it’s not likely this demand will diminish anytime soon.
The ETFs discussed here should be able to benefit from a fear-driven market environment. At the next sign of broad market weakness (characterized by an increasing number of stocks making new 52-week lows), investors should expect these defensive ETFs to show relative strength compared to the major averages.
In the meantime, if you want the best-performing growth stocks right now, while fear remains largely muted, I highly recommend subscribing to our Cabot Top Ten Trader advisory, where every week Chief Analyst Mike Cintolo provides you with 10 of the market’s strongest growth stocks from both a technical and a fundamental perspective.
To learn more, click here.
Do you agree? Which defensive ETFs carried you through the pandemic?
*This post was originally published in 2020 and has been updated.