Investors Take Defensive Turn

Investors Take Defensive Turn

By JONATHAN CHENG

Stock investors have been trading horses lately.

Out are hot "growth" stocks in the technology and energy sectors. In are the steadier, less volatile shares of utilities, health-care and telecommunications companies.

The switch has been dramatic. Energy stocks gained 16% in the year through the end of March, while health-care stocks inched up 5%, based on subindexes of the Standard & Poor's 500-stock index. Since then, health care has jumped 8.8%, while energy has tumbled 6.9%.

Health-care stocks are now the best-performing sector of the year, up more than 14% in 2011, the sector's best start to a year since 1998.

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.The sudden surge in so-called defensive stocks comes amid a debate about how the economy and stock market will perform in the second half of the year. Some investors are voting with their portfolios, shifting into companies they think will fare better in a slower-growing economy, especially as the Federal Reserve ends its support for financial markets in the coming months.

"The economy is shifting towards a slower phase than what we had seen, where riskier stocks do better," says Kate Warne, investment strategist for retail-investor brokerage firm Edward Jones in St. Louis. "As we go through this transition, where the economy doesn't grow as quickly, the steadier and less risky stocks tend to do better in that phase. This could be a very long-lasting shift."

Since the depths of the recession two years ago, stock investors have pushed the Dow Jones Industrial Average up 92% as the economy has recovered, with the help of government stimulus including the Fed's extraordinary asset purchases. Now, some are worried the economy could slump again; they flag recent data on unemployment, housing and inflation that suggest the economy remains fragile.

Others say the economy is simply going through a transition from an initial rebound to a more mature phase of expansion, a time when defensive stocks typically do best. Still others say the economy will motor ahead.

Regardless, the economic readings have served as an added source of concern for investors already eyeing the end of June, when the Fed formally ends its bond-buying program, known as quantitative easing.

Small-capitalization stocks and transportation stocks, the biggest beneficiaries of the early stages of the recovery, have flashed warning signs. The Russell 2000 index of small-cap stocks, for instance, shot up by more than 150% from its market bottom. Since hitting an all-time high in late April, however, the measure has dropped 3.3%, nearly twice as much as the broader market. The Dow Jones Transportation Average—an index of 20 airline, railroad and shipping companies considered a proxy for the economy that has also enjoyed outsize gains over the past two years—has fallen 2.5% this month.

Bond investors appear to be coming to a similar conclusion about a slowing growth trajectory. Bonds have rallied recently, a signal that investors foresee slower growth and a continued reluctance by the Fed to raise interest rates after the end of quantitative easing.

Some strategists remain confident the economy can power through this soft patch, much as it did last fall—a scenario that could see cyclical energy, industrial and tech stocks reasserting their strength as investors chase higher returns and the Fed's asset purchases continue to work their magic. Barry Knapp, U.S. equity portfolio strategist at Barclays Capital, says the recent strength in defensive stocks will be "fleeting."

Mr. Knapp says he turned conservative last spring as the Fed was ending its first round of quantitative easing and tightening monetary policy. He argues this time is different, however: While the Fed will no longer buy new assets, the central bank also has no immediate plans to start reducing its balance sheet, a stance that effectively delays the tightening cycle.

"There are a lot of strategists who think the end of easing is the beginning of tightening, and that's why people have run for defensives," Mr. Knapp says. "People haven't thought this all the way through."

During Fed Chairman Ben Bernanke's inaugural news conference on April 27, the chairman signaled that tightening wouldn't begin within the next two Fed meetings, making September the earliest for a tightening move, Mr. Knapp says.

"It's premature to be piling into defensives for something that can't happen earlier than September," he says.

The sudden move to health-care and consumer-staples stocks is the latest shake-up in a year that has seen skittish investors changing gears rapidly, part of a strategy of "sector rotation" in which money managers hop from sector to sector in search of gains.

Robert Sluymer, technical analyst for RBC Capital Markets, has been taken aback by the constant jostling.

"One group takes off, and then another group comes right up behind them," Mr. Sluymer says. "Fund managers are having a hard time trying to keep up with that rotation, trying to put money to work in one group and then another."

Early in 2011, technology stocks were the highfliers, soaring 8.4% in the first six weeks of the year and fueling chatter about a new tech bubble amid sky-high valuations for privately held companies like Facebook, LinkedIn and Twitter. But over the next four weeks, tech stocks soured as energy stocks leaped ahead, propelled by political upheaval in oil-producing North Africa and Middle East countries.

Energy stocks maintained a large lead and, until two weeks ago, were up 18% on the year. Since then, however, the steep selloff in commodities has pushed energy stocks to the middle of the pack, just ahead of the utilities sector.

At the same time, some traders see the pullback as a potential opportunity to get in. At a hedge-fund industry conference last week, Steven Cohen of hedge-fund firm SAC Capital Advisors said the recent selloff provided an "interesting entry point" for energy stocks.

Fundamental factors are at play in health-care stocks' rise. Analysts say health-care companies are well-positioned to increase profits. Health care-equipment makers and suppliers are still trading at levels that analysts consider cheap, and more health-care companies' earnings topped analysts' expectations in the first quarter than at any time in 15 years, according to Brown Brothers Harriman.

Some investors argue that shifting to more conservative stocks doesn't go far enough.

Money manager Jeremy Grantham at Boston-based GMO has been relatively bullish as the Fed's efforts lift asset prices. Now, Mr. Grantham worries that a combination of the Fed's exit from the markets and a murkier economy warrant an even more defensive stance: pulling out of the stock market altogether.

"The environment has simply become too risky to justify prudent investors hanging around," he told investors in his latest quarterly letter last week.

Write to Jonathan Cheng at jonathan.cheng@wsj.com