In these markets, you should defend yourself

DESPITE strong US and Chinese growth data and a solid – if not stellar – US earnings season, it has not been a good fortnight for global equities Since the start of the year, the S&P 500 has lost 4.6 per cent, the FTSE 100 is down 5.2 per cent and the MSCI World index has shed 6 per cent.

Indeed, in spite of the strong US fourth quarter GDP data and Ben Bernanke’s reconfirmation as Federal Reserve chairman, American stock markets struggled on Friday. Although they had initially rallied impressively on the data, the volume was thin and they proceeded to turn down substantially in later trading and on sharply higher volume.

Ever since equities started to rebound last March, each dip lower has prompted renewed concerns of a double-dip in the markets. So far, those concerns have not been realised – for one reason or another, equities remained on a firm footing in 2009. But a weak start to 2010 has made investors jittery again, and rightly so. A combination of Chinese policy tightening, US financial reforms and ongoing European sovereign debt concerns has caused the stock markets to struggle.

In such an uncertain and volatile environment, how should contracts for difference (CFDs) traders position themselves? Investors’ usual response is to head for defensive stocks – pharmaceuticals, utilities and consumer staples such as food, beverages and tobacco. These are normally considered to be non-cyclical and less dependent on the overall economic cycle as well as having low beta values – indicating that they are less volatile than the wider market. Beta is a measure of the volatility of an individual stock relative to the index as a whole.
Beta values below one indicate relatively low volatility.

Fund manager Tim Russell, who runs Cazenove’s UK Equity Absolute Return hedge fund, last week said he preferred defensives such as healthcare and utilities, which saw their performance lag the wider market in 2009, but which will provide steadier earnings in the UK recovery phase. He is short cyclical stocks at the moment because forthcoming policy tightening in the UK and moves by Beijing to tighten lending in China.

He compares cyclical mining stock Kazakhmys and defensive pharma company GlaxoSmithKline – which are both trading at 10 times earnings. Glaxo has tended to report results ahead of forecasts in recent years, while
Kazakhmys has disappointed, so Russell thinks the miner’s prices are less dependable and very reliant on those of commodities, so it should be on a p/e ratio of around six times.

UBS strategists Nick Nelson and Karen Olney agree, saying: “We are moving into a market where the extreme relative performance of the cyclicals relative to the defensives is behind us. This does not mean that the equity market has to go down, or that the economy has to fall into a double-dip,” they say. In fact, their research shows that defensives have, on balance, just outperformed the market since the end of October despite the market being up.

CFD traders can use defensive stocks in two ways. Firstly, increasing their exposure to them in order to hedge against poor performance in riskier, more cyclical positions. Secondly, as they tend to be less volatile than the overall market, they should provide more stable returns in the current environment.

But Nelson and Olney caution against focusing exclusively on defensive stocks in what is supposed to be a market recovery. They argue that in the current environment and following the dash for trash that characterised 2009 – whereby investors took advantage of the fall in share prices to pick up stocks very cheaply – investors ought to have a blend of high-quality stocks with a cyclical tilt and some cheap defensive stocks.

Their reasoning is that a lot of higher-quality, cyclical stocks got left behind last year as investors scrambled to pick up stocks with decimated share prices. By focusing on high quality growth companies that are still looking relatively cheap compared to their sector, traders can participate in the economic recovery without overpaying for it.

They recommend stocks such as Swiss engineering firm ABB, which has been an underperformer in recent months on the back of cautious comments on pricing and remains a growth story given its exposure to emerging market growth, infrastructure spending and likely mergers and acquisitions activity. Also a good pick is French industrial gases firm Air Liquide, According to UBS, the company has a mixture of both underappreciated cyclical and defensive growth, with resilience of earnings and cashflow stemming from the long-term contracts in its gas business, as well as benefiting from the consolidated nature of the industry.

The cheap defensives basket includes companies such as pharma giants AstraZeneca and GlaxoSmithKline, as well as healthcare firms like Essilor – a French optical manufacturer – and Fresenius Medical.

While defensive stocks will be a good way for you to protect your portfolio in the current uncertainty, that does not mean you should avoid cyclical stocks altogether. Those looking for a bit of short-term speculation using CFDs can look to pick up cyclical and financial stocks on the dips.