Sentiment risk to defensives

Although defensive stocks very often beat the market, there's a reason to suspect they might not do so in the next few months.

I say this because sentiment towards equities is now very depressed. A good gauge of this is the ratio of the Aim index to the All-Share, which is now close to its lowest level for over three years. Such a low level of the Aim is a sign that investors have little appetite for smaller, speculative and unfamiliar stocks, which is an indicator of pessimism and risk aversion.

And here's the thing. This ratio has some power to predict returns not just upon Aim shares but on some mainline ones as well.

Now, this is not true for the All-Share index generally. The correlation between the Aim/All-Share ratio and subsequent annual moves in the All-Share index has been insignificant. But this is because some sectors tend to rise after the ratio has been low and sentiment depressed, while others tend to fall.

The sectors that have tended to do well in the 12 months after sentiment has been depressed include: technology, media, support services, industrial engineering and electronic equipment. These are generally 'cyclical' or more speculative than others.

There's a reason for this. Sentiment tends to mean-revert; after we've been in a good mood we tend to become more melancholic, and after we've been depressed we tend to cheer up. Low investor sentiment - as measured by a low Aim/All-Share ratio - thus tends to lead to improving sentiment. And this tends to benefit those stocks that are most dependent upon economic optimism and/or risk appetite - 'cyclicals' and speculative ones.

What's more, investors tend not to anticipate these changes of mood and so they don't price in such moves in advance. This is because we are prone to the projection bias. We fail to predict that our mood will change; this is why people are more likely to buy convertible cars or houses with swimming pools in the summertime.

However, there's a dark side to all this. As investors' mood improves and they buy 'cyclicals' and speculative stocks, they rotate out of other ones. These tend to be defensive ones such as tobacco and utilities. Such stocks tend to do badly, therefore, after sentiment has been depressed - in absolute terms, not just relative ones.

Which brings us to our present problem. With sentiment now so low, mean-reversion points to it improving. And while this augurs well for Aim stocks, cyclicals and other speculative shares, it augurs badly for defensives; I stress that I'm talking of 12-month horizons here.

As a rule, investors should generally favour defensives. But in the noisy, volatile world of investing there are always exceptions to rules. And if past relationships continue to hold (always an 'if', of course) the next few months might just provide just such an exception.

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