Finding Safe Havens Amid Volatility

Defensive sectors are expected to hold up better or even advance when the economy weakens. Why? Because regardless of the economy, people have to eat, go to the doctor and turn on the lights.

"Have you noticed that while people complain about the price of gasoline; nobody complains about the price of beer or water," said Ron Muhlenkamp of Muhlenkamp & Co., with $1.5 billion in assets, in a note to clients. "The things we want are the things we'll pay up for -- and that's where the margins are. Coca-Cola KO is twice as profitable as Exxon Mobil XOM, but nobody complains about the price of Coca-Cola."

January's rate cuts screamed of a slowing economy. They were the largest Fed rate cuts since Oct. 2, 1984, when the Fed cut rates 175 basis points. Back then, two defensive sectors, consumer staples and health care, outperformed the market in the wake of the rate cut. They rose a whopping 20% and 25%, respectively, the following 12 months.

If the current nascent market rally holds, then the so-called safe-haven sectors will have provided some cushion but will not have made life cushy for those who fled to them.

The defensive sectors haven't sold off as hard as cyclical sectors like technology this time around. But none are bucking the downtrend either. While S&P has fallen 14% off its high from Oct. 11, the S&P 500 GICS Consumer Staples index has receded 7%. The S&P 500 GICS Health Care index is off 10% and the S&P 500 GICS Utilities index is down 11% from its high. Financials, which took the most severe beating, fell 30% from its peak, followed by semiconductors' -29%, consumer discretionary's -20% and telecom's -18%.

Defensive sectors sold off with the market because short-term traders and hedge funds were dumping them to raise cash, said Ron Sloan, manager of AIM Charter Fund CHTRX.

"The market was coming unglued so they sold what they had profits in," Sloan said. "Those were areas they could sell, raise cash and offset the shellacking they were taking in other areas of their portfolio."

Every sector had a good run in the prior bull market and so they were all due for a beating in a sell-off.

"(Defensive sectors) reached near record valuations a year or so ago, and so you couldn't expect anything more out of them," Sloan said.

Staple groups such as IBD's Food-Meat Products Group rose from 91st to 17th in the industry group ranking in IBD's Tuesday edition. The Utility-Gas Distribution and Medical Products groups had a handful of new highs. But the Medical Group also was home to the biggest number of new lows, followed by financials and business services.

"In the health care space, you see growth," said Paul Alan Davis, portfolio manager of mutual funds based on Schwab's equity ratings. "You see new products, new discoveries, new developments."

Davis believes health care -- which his indicators show are undervalued -- will offer more safety over consumer staples in the current environment.

Rate Cuts

Tail winds from the surprise rate cut may boost consumer staples and health care. Historically, these sectors tend to outperform after surprise Fed rate cuts, but utilities tend to lag, according to a Merrill Lynch equity strategy report.

"Utilities tend to be more severely impacted when the economy is at or near recession," Merrill Lynch analyst Brian Belski said in the report. "Unlike consumer staples and health care, utilities are much less focused on the consumer due to their higher relative exposure to the industrial and commercial segments of the economy."

On the other hand, research from Fidelity Management & Research found in the current Fed easing cycle, from Sept. 18, 2007, to Jan. 25, 2008, utilities and consumer staples held up the best. They lost 5% and 2.7%, respectively, while the market dropped 12.5%.

Financials and consumer discretionary were two of the worst performing sectors. Historically, they outperformed the market because lower interest rates spur borrowing and boosts financials and consumer spending, Fidelity's report said.