How to Play Defense in a Rocky Stock Market

Volatility is up and your portfolio is almost certainly down. Investing in these sectors will keep you in the game while holding down losses if the market heads south again.

The stock market’s head fakes can feel dizzying these days. Stocks climb one day only to tumble the next. Blink and you miss a 3% move. Indeed, had you tuned out the financial press in August, you’d have opened the papers to learn that the U.S. stock market had experienced its first correction (a decline of 10% to 20%) since 2011.

Now, with Standard & Poor’s 500-stock index down 8.6% since peaking in July, many investors are asking whether it’s time to dump stocks and load up on cash. We’d argue against such drastic measures. But it may make sense to play a bit of defense—especially if you might need to pull money out of the stock market in the next year or two.

For starters, it’s getting harder for stocks to overcome some tall hurdles. Among the biggies are a potential interest rate hike by the Federal Reserve, a slowdown in China’s economy, and a strong U.S. dollar, which is putting pressure on the profitability of U.S. companies that do a lot of business abroad. Independently, none of these things would be enough to throw the market off-kilter; combined, they make for a powerful headwind.

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A handful of stocks, meanwhile, have been doing much of the market’s heavy lifting. If it weren’t for relatively strong showings by tech darlings such as (symbol AMZN, $510.55), Apple (AAPL, $112.34), Facebook (FB, $89.89) and Google (GOOGL, $644.91), along with a few consumer and health care favorites, the stock market would be in much worse shape, says Jim Stack, editor of the InvesTech Research newsletter. Historically, things do not end well when so few companies bear the market’s weight. If more of these Herculean stocks stumble, watch out below. (Prices are as of September 2.)

Bulls, of course, argue that fears of a downturn are overblown and that stocks will resume their upward march. The U.S. economy expanded at an annualized rate of 3.7% in the second quarter—faster than any major developed country. Strong economic performance doesn’t preclude the onset of a bear market (a decline of at least 20% from a previous peak), but makes one less likely in the near term. Kiplinger expects real gross domestic product to expand by 2.5% for all of 2015 and by 2.8% in 2016.

Stocks look cheaper as well, with the S&P 500 trading for a bit more than 15 times estimated earnings for the next 12 months. That’s below the market’s 20-year average P/E of 16.4, according to UBS, which says stocks look “undervalued.”

Yet stocks aren’t really cheap if analysts start to ratchet down their earnings estimates. Many companies have in fact been slashing their projections for third-quarter earnings; out of 106 S&P 500 businesses that have issued forecasts, 76 have reduced estimates, according to FactSet. Overall, Wall Street expects S&P 500 earnings to slump by 4.1% in the third quarter compared with the same period in 2014, and to inch up by 1.8% in the fourth quarter of 2015. Much of the weakness in earnings has been due to a steep slide in energy-industry profits, which plunged 55.6% in the second quarter. Hopes are higher for an overall rebound in 2016, with industry analysts projecting a 9% climb for S&P 500 profits.

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With so many crosswinds buffeting the market, it may be a good time to get defensive. We don’t advise jumping out of stocks, because you’ll be hard-pressed to know when to jump back in for the recovery. But some sectors and stocks tend to be more resilient in turbulent times, offering a bit more protection than others.

Two sectors that look compelling now: health care and companies involved in consumer necessities. Both tend to be relatively strong in periods of rising interest rates, says Stack, and they should hold up better if stocks take another turn for the worse. He advises putting 13% of your stock assets in consumer staples and 16% in health care.

Exchange-traded funds that track market indexes can get the job done. The Consumer Staples Select Sector SPDR Fund (XLP, $46.97) and Health Care Select Sector SPDR Fund (XLV, $70.05) each charge 0.15% annually for expenses, and both closely track their respective parts of the market. Another option: Buy Berkshire Hathaway (BRK.B, $132.22), Warren Buffett’s holding company. Berkshire’s businesses include insurance company Geico and railroad Burlington Northern Santa Fe, along with stakes in publicly traded companies such as American Express (AXP, $74.94), Coca-Cola (KO, $38.90) and DaVita HealthCare Partners (DVA, $75.12). These are solid businesses that should pump out profits even in a downturn. Buffett is now adding to his collection with a deal to buy aerospace parts maker Precision Castparts (PCP, $229.25) for $32 billion. Buffett says Berkshire will have more than $40 billion in cash on its books after the merger closes. Shares of Berkshire have slumped 12% this year, enhancing their attractiveness.

Buffett has also been dipping into the energy patch, building a $4.5 billion stake in refiner Phillips 66 (PSX, $78.56). Oil refiners such as Phillips make more money when crude prices are low because their costs are lower. Phillips also looks attractive because the company is investing in storage, transportation and processing, which have steadier income streams and lower the company’s exposure to volatile energy prices.

Oil-and-gas giant Chevron (CVX, $78.06) looks like another defensive energy play. Chevron’s profits have tumbled because of low oil prices. But the company should be able to maintain its quarterly dividend of $1.07 per share, says Gary Bradshaw, manager of the Hodges Equity Income Fund (HDPEX). The stock yields 5.5%, compared with 2.1% for the S&P 500. Although the company doesn’t appear to be making enough money to cover the dividend, it has issued more debt, cut spending and suspended share buybacks to fund future payments. Moreover, Chevron plans to boost oil-and-gas production in 2016 and 2017 as new projects come to fruition. At least one company insider seems to like the stock, too: Chevron director John Stumpf bought shares worth $19.5 million in May at an average price of $108.10 per share.

Utilities and pipeline companies that distribute natural gas look attractive as well. These are “toll-taker” businesses that benefit from low and stable gas prices, says Ryan Kelley, co-manager of the Hennessy Gas Utility Fund (GASFX). Some yield 5% or more, including CenterPoint Energy (CNP, $17.72), Kinder Morgan (KMI, $31.31) and Williams Companies (WMB, $47.21). None should have trouble making their dividend payments, says Kelley, and profits should rise as growing quantities of gas flow through their pipes.

Granted, utilities and pipeline stocks could slump if interest rates spike. Higher rates increase financing costs for these companies, which have heavy debt loads, and the stocks could slide if investors dump them for bonds or other income investments. Still, natural gas production is rising, along with demand for the fuel source. As long as gas stays cheap and plentiful, Kelley says, “these companies will chug along just fine.”

Daren Fonda
Senior Associate Editor, Kiplinger's Personal Finance
Daren joined Kiplinger in July 2015 after spending more than 20 years in New York City as a business and financial writer. He spent seven years at Time magazine and joined SmartMoney in 2007, where he wrote about investing and contributed car reviews to the magazine. Daren also worked as a writer in the fund industry for Janus Capital and Fidelity Investments and has been licensed as a Series 7 securities representative.