MACROSCOPE No. 31: Striking a balance between offense and defense

Elvis Picardo

May 8, 2020

Times like the present underscore the importance of holding an investment portfolio that strikes a balance between offense and defense, much like the best teams in any sport. In investment parlance, that means holding a portfolio mix of stocks and securities that will do well in a strong economy while mitigating some of the downside risk when the economy is struggling.

The most widely-used classification divides stocks and sectors into two categories – cyclical or defensive.

Cyclical stocks, as the name suggests, are geared to the economic cycle and outperform their staid defensive counterparts when the economy is on wheels; the flip side of that outperformance means that they underperform when the economy hits a roadblock. Defensive stocks, on the other hand, inhabit stable, “Steady Eddie” sectors that are comparatively immune to the economic cycle and chug along in good times and bad.

MSCI Inc, a leader in the methodology and construction of market indexes, classifies the following sectors as Cyclical sectors – Consumer Discretionary, Financials, Real Estate, Industrials, Information Technology, Materials and Communication Services. It classifies the following as Defensive sectors – Consumer Staples, Energy, Healthcare and Utilities.

The classification of a sector or stock as Cyclical or Defensive is intuitively easy to understand in some cases, but somewhat difficult to comprehend in others. For example, is Energy really a defensive sector, given the gyrations of oil and gas prices over the past two decades, and the consequent mayhem in the energy sector?

And should Information Technology and Communication Services be considered cyclical, given their importance in our daily lives, as the ongoing lockdowns and social distancing measures have vividly demonstrated? This reliance on technology and communications has enabled companies like Amazon and Netflix to outperform the broad market by a huge margin even in the current environment of sharp economic deceleration.

To address some of these obvious disconnects, fund company Morningstar rolled out its own classification system about a decade ago, adding a third category called “Sensitive” that includes industries with some degree of correlation with the economic cycle, but not as much as the Cyclical sectors. “Sensitive” sectors include Communication Services, Energy, Industrials and Technology.

Portfolio Implications

In our client portfolios, we hold a diversified mix of stocks and securities belonging to these sectors. Exposure to the technology giants that currently dominate the S&P 500 is obtained through the Invesco Top 50 S&P 500 ETF (XLG) as well as a top-performing global growth fund. Our portfolios include defensive stocks such as Hydro One, Johnson & Johnson, and Loblaws, as well as stocks like Disney, Qualcomm and Visa that will outperform in a strong economy.

On an interesting note, some of our portfolio securities that rebounded the most in April were the ones that endured the biggest declines in March. These included pipeline operator Pembina Pipeline, auto parts manufacturer Magna, holding company Restaurant Brands (which owns Tim Hortons and Burger King), as well as the CI First Asset Canada Momentum ETF (WXM).

There is a distinct possibility that the markets will retrace some of their stellar gains (32.8% for the TSX, 31.4% for the S&P 500) from the March 23 lows. While our investment portfolios continue to have a defensive tilt, a significant portion of our portfolios is positioned for the inevitable recovery as and when life returns to normal.

This information has been prepared by Robert Luft and Elvis Picardo, who are Portfolio Managers, and Aaron Arnold, who is an Investment Advisor, for HollisWealth® and does not necessarily reflect the opinion of HollisWealth®. HollisWealth® is a division of Industrial Alliance Securities Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. Robert Luft, Elvis Picardo and Aaron Arnold can open accounts only in the provinces in which they are registered. For more information about HollisWealth, please consult the official website at www.holliswealth.com. Luft Financial is a personal trade name of Robert Luft.