A historic shift toward Defensive and Value stocks

Key points:

• Defensive stocks outperformed Cyclical ones by more than 7% over the past month
• Value outperformed Growth, also by more than 7%
• When both "safe" factors outperformed their "risky" counterparts by so much, stocks struggled

Investor preference for Defensive and Value stocks hits historical proportions

Over the past month, we've seen a massive shift. Investor sentiment turned sour on Cyclical and Growth stocks, greatly favoring Defensive and Value factors.

It has eased back over the past few days as risk appetite made a comeback, but using a rolling 21-day lookback, Defensive stocks outperformed Cyclical by more than 7%. So did Value stocks over Growth. Both ratios eased a bit in recent days, but their outperformance is still notable and is among the most extreme moves in years.

Going back to 1928, this 7% relative outperformance in both Defensive and Value stocks is remarkable. The chart below shows the minimum rolling 1-month return between Defensive - Cyclical stocks and Value - Growth stocks. If it's positive, then it means that investors favored both Defensive and Value stocks.

Not only was the recent spread positive, it was also historically so. There have only been a few other times since 1928 when investors so heavily favored Defensive and Value stocks over Cyclical and Growth.

It would be easy to highlight 1929 and 2000 and suggest this is a sign of the apocalypse. It's harder to reconcile 1984, which preceded a few months of choppiness, then a fantastic bull run.

Lesser outperformance for Defensive and Value stocks preceded better returns

It's hard to rely on a sample size of 3. If we relax the threshold to 5% outperformance, then we get quite a few more precedents, though the last signal was still 16 years ago.

Looking at forward returns after those signals, returns in the S&P 500 improved and were quite good over all time frames. Since 1950, almost all the signals showed a positive return over the next 1-3 months, and most of them extended those gains in the months ahead.

Returns in the factors themselves were mixed. After the few periods of 7% outperformance, Defensive stocks continued to outperform Cyclicals and Value stocks outperformed Growth. But again, a sample size of 3. Unfortunately, the implications weren't consistent when we reduced the threshold to 5% outperformance. After those signals, there was much less consistency.

What the research tells us...

This is one of those tough periods when we have to judge how much weight to give the outstanding outperformance of Defensive and Value stocks. The few precedents are clear that stocks, in general, tended to suffer, with Defensive and Value stocks adding to their gains versus higher-risk factors. But a modest reduction in the extreme greatly changed the outcomes, which makes it much harder to rely on the signal as an input.