Decoding Markets: Playing Defense

Estimated reading time: 5 minutes

Crumbling Sentiment

Darkening macro clouds are evident in a wide variety of so-called soft data (qualitative information collected through surveys). According to the American Association of Individual Investors, over the last two months, there have been roughly twice as many bearish investors as bullish ones. That’s not a major surprise given the steady drumbeat of negative news on the trade front. 

However, this pessimism has also found its way to business executives. Several regional Federal Reserve banks conduct monthly surveys of manufacturing and services businesses in their districts to get a feel for how operators see things. By incorporating their views on factors like orders, workforce activity, and price trends, the Fed banks publish indexes to approximate overall activity. While April data remains partial, the composites across regions have fallen into firmly negative territory (0 = neutral).

Although manufacturing input costs are generally more exposed to imports, the economy is interconnected enough that major shocks reverberate throughout markets. An increase in input costs will probably raise costs for most firms and weigh on demand. Higher costs and lower demand is a recipe for margin pressure, and recent business pessimism reflects that concern.

Deterioration and Rotation

The S&P 500 remains nearly 13% off its all-time high of 6144 set on February 19, yet it has rallied 8% since closing at 4982 on April 8 on fresh hopes for a resolution to the trade impasse. Nonetheless, it’s hard to envision stocks setting new records in the near-term: Recent upheaval can’t just be forgotten. Technical trends have been damaged and investor sentiment could take time to rebound.

A key element of the current market backdrop has been the rotation between cyclical and defensive stocks. When investors are optimistic about economic growth, they tend to favor cyclical sectors like consumer discretionary that benefit from economic expansion. When concerns about economic contraction emerge, money tends to flow toward defensive sectors like utilities and consumer staples with more stable earnings profiles. 

Given the macro backdrop, one would expect defensives to be outperforming cyclicals. That’s exactly what has been happening.

Hardening Data

Up until recently, markets have largely traded on the unknown and its possibilities. Economists have rapidly revised their growth expectations downward, with consensus now expecting the U.S. economy to expand by 1.7% in 2025, significantly below the 2.3% expected at the end of February. Of course, soft data has helped explain the shifting landscape, but that isn’t a replacement for hard data (i.e. factual and reliable statistics). The wait is almost over now, though, as April data starts getting released in the coming weeks.

Critical economic indicators such as the unemployment rate, inflation, and consumer spending will all go a long way in shaping how markets trade over the coming weeks. An important caveat, however, is that market risks here are likely to be asymmetric. Weak jobs numbers or hot inflation reports could have a greater impact on markets because they’d confirm investors’ fears. Conversely, better-than-expected data could get shrugged off due to the possibility that the trade upheaval might just take a bit longer to reflect in the hard data, perhaps because some spending was pulled forward to get ahead of tariffs going into effect.

In this volatile environment, it might be prudent to maintain (or adopt) defensive positioning until greater clarity emerges. Of course, market timing is notoriously difficult, and periods like the one we’re in can lead to poor decisions. It’s why getting completely out of the market tends to be the wrong move, since missing even a few of the best days has a major effect on investment returns. And as discussed two weeks ago, the best days of returns tend to cluster around the worst days.

When times are easy, diversification might not seem important. But when times are tough and emotions are high, diversification across sectors, regions, and assets pays off. Stick to it. 

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