The Defensive Team Takes the Field

Tobacco, food and drug stocks start to lead the market while tech and small-caps fade, suggesting investors are starting to shun risk.

Technology and small-capitalization have been leaders at various times in the stock market's climb from last August's lows, and some see their continued leadership as critical in sustaining the market's advance.

onversely, traditionally defensive groups such as tobacco, food and drug stocks seem to do better than more discretionary areas when the bears are flexing their muscles.

I recently wrote that technology and semiconductors in particular had turned the corner from bull to bear (see Getting Technical, "Don't Buy Chips on the Dip," April 4, 2011). At about the same time, relative performance by defensive sectors started to improve. The divergence suggests the market's tone has changed: Investors are starting to shun risk.

To be sure, sentiment surveys, such as Investors Intelligence and the Hulbert Stock Newsletter Sentiment Index, still point to happy bulls and complacent investors. The Chicago Board Options Exchange volatility index—known better by its ticker, the VIX—dipped to a low level not seen since before the Libyan conflict began, implying there is little fear out there.

But sector action tells us something has changed. For example, tobacco stocks such as Altria Group (NYSE: MO - News), Lorillard (NYSE: LO - News) and British American Tobacco (NYSE: BTI - News) are at all-time highs. In contrast, the Standard & Poor's 500 has failed to eclipse its February 2011 high, let alone come close to its 2007 peak.

Drug stocks are not quite as strong, but the Merrill Lynch Pharmaceutical Holdrs Trust (NYSE: PPH - News) quickly shook off last month's weakness to touch a 52-week high (see Chart 1).

Aside from breaking through chart resistance, this exchange-traded fund shows a clear shift from market laggard to market leader in February. Along with tobacco stocks, food producers such as Ralcorp Holdings (NYSE: RAH - News) and H.J. Heinz (NYSE: HNZ -News) have moved atop the leaderboard.

The last piece of the shift from offense to defense puzzle is the small-cap sector. While the Russell 2000 index still is leading its bigger cousins on a relative basis, it now sports a potential technical failure (see Chart 2).

In early March, the small-cap gauge moved below the rising trendline from its August low. Events following the Japanese earthquake and tsunami sent the entire market lower, but unlike most major indexes, the Russell 2000 came roaring back to set a new high. That is the good news.

The bad news is that, over the past week, it has fallen back below its February high. That is arguably already what chart watchers call a "breakout failure." In technical lore, a move above a resistance level that does not hold suggests that the index used up its last bits of fuel. Demand then gives way to supply and prices move lower.

The shift from traditional leaders in rallies to traditional hiding places in troubled times is clear. It does not mean the bull market is necessarily over. But with major indexes failing to break respective resistance levels, and the only one that did—the Russell 2000—now failing to hold, the bears' arguments are growing more persuasive.