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Time to Get Defensive

Jeff Bagley

You can call it profit-taking, a pause that refreshes or any other euphemism for the ugly action we've seen recently. What I see underneath the action is a barely discernable rotation into defensive stocks, no doubt in response to economic data that continue to come in very weak, especially on the industrial side of the economy.

I am still bullish on the economy, but I believe it's prudent to diversify with stocks that can withstand slower economic growth ahead. Later in this column I'll name some names.

But the big picture first: With so many investors looking over the current valley of economic weakness to better times ahead -- as measured by the huge market run since the summer lows -- this market needs some better economic news.

While a weak dollar is not necessarily a bad thing, it does make it a tad more difficult for the Fed to cut rates next year. That's what everyone is counting on, especially the financial sector, which was counting on the yield curve growing more normal, not more inverted.

For the most part, there is a lot to like in equities. However, I believe caution is warranted. Increasing defensive holdings might not be such a bad idea at this juncture, especially those that will benefit from a weaker dollar.

The most recent durable-goods data were darn ugly, with orders, excluding transportation, down 1.7%. That was significantly lower than the 0.2% gain economists were forecasting.

Unfortunately, this is merely the latest in a string of weak economic numbers. In early November, the ISM manufacturing survey came in at 51.2, below expectations and barely showing growth. In other releases, factory orders were weak, as were industrial production, housing starts, building permits and payrolls. Adding insult to injury, recent readings indicate that non-farm productivity gains have stalled.

It's Not All Bad

Of course, the numbers aren't all bad. The ISM non-manufacturing index was better than expected, and many consider that reading to be more important than its industrial counterpart, given the importance of the service sector to the U.S. economy.

Inflation numbers also continue to show that the inflation threat has diminished greatly. This has been corroborated not only by the consumer price index and producer price index readings but by the inflation components of the two ISM reports. Bond investors have also signaled that inflation is well under control -- despite the hawkish jawboning by the Fed -- via both the fall in absolute yields and the narrowing of the spread between nominal Treasury yields and the yields of the inflation-protected securities (TIPS).

The recent fall in energy prices has a lot to do with the fall in inflation readings and inflation expectations, and that has led to an increase in consumer confidence, the latest weaker-than-expected number notwithstanding. Retail sales were better than expected in September, but on the negative side, they were really nothing to write home about in October.

In summary, things are not all that bad in the economy. The real question, in my mind, is just how damaging the currently weak housing market will be to the rest of the economy. Put simply, sector dislocations often take time to fully play out.

For my part, I am a bottoms-up investor, so I will continue to hold stocks like Apple (AAPL Quote), Boeing (BA Quote), St. Paul Travelers (STA Quote) and American International Group (AIG Quote). While everything is economically sensitive to some degree, these stocks are currently enjoying earnings growth that will hold up even with a weaker economy. These growth stories continue to be underappreciated by investors, in my view.

But I do have a generous portion of defensive holdings. For example, I own Procter & Gamble (PG Quote), Johnson & Johnson (JNJ Quote), Pfizer (PFE Quote) and GlaxoSmithKline (GSK Quote). I group these stocks together because they are weak-dollar beneficiaries, but stocks such as Duke Energy (DUK Quote) and Dean Foods (DF Quote) also offer appealing defensive growth opportunities

Other defensive holdings that are currently priced attractively because of investor fear are UnitedHealth Group (UNH Quote) and Caremark Rx (CMX Quote).