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Defensive ETFs Can Protect You from the Next Market Crash

From an evolutionary perspective, we humans have a lot to worry about. Our brains developed fear and worry as a survival mechanism. If you were living with a community of hunter gatherers some 150,000 years ago, fear is what helped you realize that you needed to run from that 240-pound dire wolf heading your way. I don’t know about you, but that’s one thing I’m glad I don’t need to worry about.

Worry, however, can have benefits for savvy investors who know how to take advantage of it. You’re probably familiar with the old Wall Street adage that says “bull markets climb a wall of worry.” This bromide has certainly been proven since the U.S. stock market bottomed earlier this year, and there is currently no shortage of things for investors to worry about. But as long as the market’s technical backdrop remains strong, the bull should be able to feed off this worry (which typically creates a rapid pile-up in short interest that can quickly ignite short-covering rallies).

But what happens when the market’s internal condition eventually begins to weaken and those widespread worries show no sign of diminishing? This was precisely the condition that precipitated the late-February sell-off in the major averages, as investors’ fears over the spreading coronavirus served to fuel the selling pressure, which only intensified in March. That double-edged sword of worry, as it pertains to the stock market, is a good reason to hedge your portfolio against another fear-driven market decline. It’s never too early to prepare a strategy to protect your portfolio from the next market correction.

One of my favorite indicators for gauging the internal strength or weakness of the broad market is the number of stocks making new 52-week highs and lows. The new highs-lows reflect the incremental demand for equities, and in a healthy market environment, there should be fewer than 40 stocks making new 52-week lows on a daily basis. New 52-week highs, by contrast, should ideally outnumber new lows by a ratio of 3:1 or greater.

When the daily number of stocks making new lows on both the NYSE and the NASDAQ is below 40, that tells us that selling pressure is virtually non-existent. But sooner or later, the new lows will begin to increase while the new highs will contract. Once the new lows rise above 40 for several consecutive days, you’ll know it’s time to begin “pulling in the horns” by trimming laggards from your portfolio, raising protective stops on existing long positions and looking at potentially attractive defensive stocks and ETFs to rotate into.

The danger of a market in which new 52-week lows are above 40 (and rising) is that stocks in general become far more vulnerable to negative headlines and worries. While stocks typically ignore bad news and feed on fear during a strong market environment, in a market characterized by internal weakness, investors’ fears can become self-fulfilling as selling begets more selling (with no one interested in buying the dips).

Fear, then, can be beneficial for stocks in an internally strong environment, but detrimental to stocks when the market’s backdrop is technically weak.

When the new 52-week lows are steadily increasing, fear is most likely to drive stock prices lower.

4 Defensive Investments to Hedge Against Worry
One of the first things you should do when the market starts showing signs of internal weakness is to look for areas of the market which were ignored during the rally phase. Underachieving sectors and industry groups often (though not always) become the new leaders once a market correction has ended as institutional investors typically seek out-of-favor stocks to rotate into. And if these ignored sectors happen to be defensive in nature, it increases the odds that such stocks will rally during—or immediately after—a market downturn.

Utility Stocks
One such group that has been largely ignored during the latest phase of the bull market is utilities. Utility stocks have a long-established history of being among the most defensive stocks since we all need water, gas and electricity regardless of the business climate (even in a recession). Utility companies have the added attraction of benefiting from the lower interest rates that are prevalent right now.

I expect that utility stocks will begin outperforming the major averages once we’ve entered another down phase in the market.

Consumer Staples
Another traditionally defensive area of the market is consumer staples. Consumer staples typically perform well in a recession; after all, people will always need to buy things like shampoo, toothpaste and toilet paper. The staples also tend to outperform when high-flying leaders—like the big tech names—come under selling pressure.

Another way to benefit from a fear-driven market is to watch the asset class that has always historically served as a hedge against a weak stock market. I’m referring, of course, to gold, which typically benefits when worries abound. Accordingly, gold is one of the ultimate safe haven assets which investors should consider owning in a fear-driven market.

While it’s commonly believed that gold always trades inversely to the stock market, that hasn’t been the case in recent years as both gold and equities have simultaneously risen for extended periods. The reason for gold’s persistent strength is plainly evident in the daily news headlines, which continue to reveal spiking coronavirus cases in the U.S. There are also lots of geopolitical risks and worries over the strength of the global economy. With such worries abounding, gold should have a built-in psychological support for months to come.

U.S. Treasury Bonds
A final consideration for a fear-driven market is U.S. Treasury securities, which are normally in high demand during periods of heightened stock market volatility. T-bonds have benefited from safety-related demand in recent years, and it’s not likely this demand will diminish anytime soon.

The sectors should be able to benefit from a fear-driven market environment. At the next sign of broad market weakness (characterized by an increasing number of stocks making new 52-week lows), investors should expect these defensive sectors to show relative strength compared to the major averages.