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Twin peaks

Defensive and speculative stocks have both done well recently. This is unusual, and it might not last.
September 24, 2020

Aim shares are on a great run. In the past six months they have risen more than 50 per cent, far exceeding the All-Share index’s 19 per cent gain. It’s tempting to see this as a sign that investor sentiment has improved – perhaps the same sort of improvement that has also seen big foreign buying of US equities recently.

Such an explanation, however, runs into a big problem. It’s not just small speculative shares that have done well recently. So too have defensive shares: my no-thought portfolio of lower-risk stocks has risen 43 per cent in the past six months.

Investors, then, have been so exuberant that they’ve piled into speculative stocks, but also so cautious that they’ve been buying the most defensive ones.

This seems weird. And it is historically unusual. It’s been much more common for Aim shares and defensives to move in opposite directions relative to the All-Share: when Aim does well, defensives under-perform and vice versa. Since 2006, the correlation between three-month returns on the two segments of the market relative to the All-Share index has been minus 0.54. For example, defensives under-performed in 2010 and in 2016-17 when Aim did well, but out-performed in 2011-14 whilst Aim under-performed.

It’s not just changes in investor sentiment that have generated this negative correlation. Defensive stocks, historically and around the world, have traditionally been underpriced and so have outperformed on average. Conversely, investors have generally paid too much for smaller speculative shares, perhaps because they have over-estimated the tiny chance that smaller companies will grow quickly, with the result that Aim shares have generally underperformed. The favourite-longshot bias – gamblers' habit of betting too much on outsiders and not enough on safer bets – applies to shares as well as horses.

All of which poses the question. Why, then, have we seen the weird pattern in the past six months of Aim and defensives doing well together?

One reason is that during the panic in March, credit conditions tightened. One effect of this was to hurt Aim shares: smaller stocks are traditionally sensitive to changes in credit conditions, partly because many of them don’t have the cash piles that bigger companies do. But the tightening also hurt defensives: my portfolio of these actually under-performed during the worst of March’s rout. There’s a reason for this. When credit is tight, bullish investors cannot express their bullishness by borrowing to buy shares generally. Instead, they take a geared position on the market by selling defensives and moving into higher beta shares, thus raising the beta of their equity portfolios. This mitigates the tendency for low-risk shares to outperform in downturns.

These mechanisms mean that in mid-March both Aim and defensives were cheap. And as credit conditions normalised, both recovered.

This is not unprecedented. In 2009 and after the euro crisis in 2012-2013, easing credit conditions allowed both defensives and Aim shares to do well.

A second factor is valuation cycles. At the end of last year, both defensives and Aim shares were relatively cheap – at four and two-year lows relative to the All-Share. Such cheapness has unwound this year.

But there’s something else. The story of Aim and defensives this year is not entirely about them at all. It’s about the All-Share index.

This year, the UK market has in a sense been the mirror image of the S&P 500. Whereas the latter has been boosted by fantastic performance by some of its biggest stocks such as Amazon, Apple and Microsoft, the UK index has been held down by its biggest shares. At the start of this year, BP, Royal Dutch and HSBC were three of the largest members of the index, accounting for almost 17 per cent of it. All have fallen by more than half since then. These three falls alone have wiped almost 10 percentage points off the index.

If you had avoided these three and had average luck, you would have beaten the market. And both Aim shares and my defensive portfolio did avoid them. Which added to their outperformance.

All of which leaves investors in both with a problem. All these factors behind their good performance have now disappeared. Credit conditions have normalised. Both segments are now no longer cheap: in fact, defensives are at a record high relative to the index and Aim at a 10-year high. And there’s no convincing reason to expect mega-caps to continue to catastrophically under-perform.

All of which points to worse performance in both sectors in future.

This isn’t a reason to dump them both immediately. Aim shares benefit from momentum effects, and defensive investing is a good long-term strategy. But it is a case for greater caution.