Is It Finally Time To Get Defensive?

By Aaron Levitt | July 31, 2014 AAA

It’s been a heck of a ride for equities over the last few years. After bottoming out during the Great Recession and credit crisis, stocks have climbed to lofty heights. Ignoring a few dips along the way, the S&P 500 — as represented by the SPDR S&P 500 (SPY) — is up over 113% over the last five years. Likewise, the Dow Jones Industrial Average and Nasdaq index have all recently flirted with new highs. All in all, it's been a great time to own stocks.

And that has many investors and market-watchers wary.

After such a torrid surge upwards, it’s getting harder to please investors. Cracks are starting to form and predictions of a bear market are starting to be made. For investors, the continued rise amid concerns of a correction could be the signal to start looking at getting defensive. (For related reading, see: Connecting Crashes, Corrections and Capitulation.)

Trouble Brewing?

First, when looking strictly at metrics, stocks are getting a tad expensive. The S&P 500’s current P/E of around 18 is well above historic norms of around 15. At the time same time, economist Robert Shiller’s cyclically-adjusted price-to-earnings ratio – or CAPE ratio – is insanely high. Unlike the standard P/E, which looks at earnings of one year, CAPE looks at average profits over the last ten years. Historically, the CAPE of the market is around 16. Today that number is 26.3. Essentially, that means that stocks are around 40% overvalued than their traditional historic averages.

Those earnings haven’t exactly been very robust, though. A variety of companies that have recently released earning reports have either missed expectations or relied on cost cutting measures rather than revenue growth to bolster their results.

Another poor sign for stocks are the recent stumbles seen in the housing market. Recent data show that housing starts plunged 9.3% and new building permits tumbled 4.2% last month. Meanwhile, new home sales nationwide fell by 8.1% in June. Considering how important housing is to the economy, none of these data figures are encouraging. (For more, see: Understanding The Case-Shiller Housing Index.)

Adding in the recent global issues in Europe and key emerging markets like China, and the various threats of war across the global, and that correction could be here sooner rather than later.

Time To Get Defensive 

Wary investors should examine more “defensive” investments. While the ride could continue, stocks could also go sideways. Luckily, there are plenty of ways for regular retail investors to position themselves for the potential strife ahead. A prime way is through the Guggenheim Defensive Equity ETF (DEF). (For more, see: What Are Defensive Stocks.)

With “defense” in its name, DEF focuses on stocks with low valuations, conservative accounting and a track record of outperformance during sliding markets. Currently, the ETF tracks 101 different stocks, including “boring” names like waste management company Republic Services, Inc. (RSG) and pipeline firm Energy Transfer Equity LP (ETE). That focus on defensive sectors and dividends has allowed the ETF to hold its own during markets downturns. DEF lost less than the overall market during the major panic in 2008-2009. And if the markets drift sideways, DEF should be able to withstand any bumps. (For more, see: Guard Your Portfolio With Defensive Stocks.)

Also on a more defensive stance are the so-called low-volatility funds. The iShares MSCI USA Minimum Volatility (USMV) and the PowerShares S&P International Developed Low Volatility (IDLV) bet on stocks that tend to move within a narrow range compared to their respective indexes. Such funds smooth the ride for investors, though some upside is likely to be sacrificed. (For more, see: How To Day Trade Volatility ETFs.)

However, low volatility or defensive equity funds may not protect your portfolio if a widespread correction happens. To that end, moving some of your holdings into dedicated short funds may be in order. The ProShares Short S&P 500 ETF (SH) allows you bet against the benchmark index and its extremely high CAPE ratio, while the actively managed AdvisorShares Ranger Equity Bear ETF (HDGE) uses a variety of screens to create its portfolio of overvalued stocks ready to fall. Both funds have performed quite badly in the upwards trending market, they have managed to capture the downside during any recent hiccups. Both HDGE & SH could be great ways to protect your portfolio.

The Bottom Line

While it hasn’t happened yet, signs are pointing to the fact that stocks are a bit frothy and a major correction could be near. For investors, getting a bit more defensive could make sense. 

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