Fidelity’s Chisholm Says Defensive Stock Rally Not Close to Done

  • Current run is only a third of the average historic magnitude
  • Contracting earnings growth suggests strength will continue

Investors looking to beat the stock market over the next year should take this simple piece of advice: Follow the leaders.

With corporate profits headed for a sixth straight quarterly decline, the market’s defensive sector-led rally has even more room to run, according to analysis by Denise Chisholm, a sector strategist in Denver for Fidelity Management & Research.

Why? In a word, history.

Based on similar profit contractions dating back to 1962, the combined strength of utilities, phone companies, consumer-staples and health-care -- which as a group are among the best performers in the S&P 500 Index this year -- is still only one-third of its average magnitude, according to Chisholm. And the run is just midway through its average duration, she added.

“History says that the defensive rally isn’t over yet,” Chisholm said in an interview in New York on Tuesday. “You should buy defensive sectors if you think earnings growth will continue to contract, regardless of what you think is going to happen with interest rates or the economy.”

Even if the Fed raises rates at the conclusion of Wednesday’s meeting or by year-end, the safety trade isn’t likely to go away until there’s a more sanguine outlook for corporate profits, Chisholm said. In addition, for all the grumblings that these stocks are too expensive and provide tenuous support for a market that’s achieved 10 new highs this year, their strength isn’t necessarily a bearish signal.

“This doesn’t have to be a recessionary call,” Chisholm said. As an example, she points to a period of outperformance for these stocks in 1997 and 1998 that coincided with the Asian financial crisis, a time that saw U.S. corporate profits contract without producing a recession.

While the four defensive sectors combined are leading the market, there are variations within the group. Shares of phone companies, which rose 0.3 percent as of 12:22 p.m. in New York, have outpaced the benchmark by 7.8 percentage points this year, while health-care stocks are lagging the market by 4.9 percentage points.

But despite the group’s overall strength, Chisholm said the stocks still have room for growth. For example, when consumer staples hit a price-earnings ratio of about 23.4 in mid-July -- a 14-year high for the industry and nearly 20 percent premium to the benchmark -- it still wasn’t necessarily a sign of coming weakness, she said. Rather, history suggested the shares still had an 80 percent probability of outpacing the benchmark over the next 12 months.

Analysts predict profits among companies in the four defensive groups will grow in the final two quarters of the year, building on gains in the most-recent quarter that came amid a broader market contraction

“This is really an earnings story,” she said. “That’s where history can help.”

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