Les Bon Temps Roulez (For Now)

Les Bon Temps Roulez (For Now)

Despite the strength of recent gains in U.S. stocks, many investors remain skeptical of the market's prospects in 2018. Low volatility strategies can provide a measure of comfort by seeking enhanced stability while maintaining equity market exposure and the potential for further gains.

Can stocks’ long run continue?

Investors typically pay less attention to risk factors in the later stages of an equity market rally, expecting the good times to continue to roll. Indeed, excessive enthusiasm among individual investors and the indiscriminate buying it inspires are viewed by many as classic signs that a market may be nearing a top.

But curiously, after the most remarkable run in modern history – with the S&P 500 going almost 9 years without a bear market, returning over 300% since the end of March 2009* – many investors seem less than ebullient.

On the one hand, they have proved highly resilient in the face of multiple headline risks (most recently North Korea missile tests, Iran/Saudi proxy wars, and U.S. political turmoil). And not without reason: global reflation, strong earnings and the prospect of tax reform create a compelling positive narrative, and traditional economic measures are not flashing warning signs.

On the other hand, the current bull market has been characterized as the “least loved in history”.  Investors are thrilled to see the indexes hit high after high, yet financial advisors report an undercurrent of anxiety about where stocks may go from here.  That could help explain the recent behavior of mutual fund investors, who as a group withdrew money from equity strategies rather than adding to their holdings in 7 out of 8 months from April through November last year– hardly a giddy endorsement of the market’s future prospects.

U.S. Domestic Stock Fund Flows, by Month

Source: Investment Company Institute

Volatility on vacation

For now, certainly, fear appears to be taking a backseat to optimism – reflected not only in recent gains but also remarkable absence of volatility in stocks now.  But is ultra-low volatility unequivocally positive?

Consider the standard deviation of price returns – the most direct measure of overall market volatility.   Examining 30-day rolling periods for S&P 500 daily performance (a measure that smooths out the effect of days that are true outliers), one must go back to the mid 1960’s (specifically, from mid-1964 through 1965) to find an extended period of quiet more extreme than what we have seen over the past year.

S&P 500 Daily Volatility (rolling 30-day), 1951-2017

Source:  Bloomberg, 12/31/17. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

A similarly unusual pattern now prevails in the VIX Index – a commonly cited barometer of volatility --– which has recently hovered at the lowest level in its 17-year history.  The Index, based on patterns of options trading, measures expectations of near-term stock market volatility – and suggests traders aren’t worried about imminent change to the current narrative in stocks.

What’s the catch?

But the VIX is not only low in absolute terms, it’s also out of its normal range -- in fact, more than a standard deviation outside of its long-term average. Statistical anomalies like that are always worth a second look.

For investors who wonder if the current extreme levels of low volatility can continue, the critical question now is not whether stocks are overvalued but how much farther they can run.  The S&P 500 is up over 25% since Trump’s election. How much are current  expectations of future growth based on tax reform, deregulation and infrastructure spending. could already be reflected in current pricing?  

There’s also the issue of market breadth. The big gains for the overall market don’t apply to every stock or sector.  Some still trade at valuations well under historic highs. Massive valuations for mega-cap technology stocks continue to dominate the totals.  Looking at the relative gains of the S&P 500 for the year is instructive; Energy and Telecommunications stocks were flat in 2017 and

Big gains, but not across the board


S&P 500 Sector2017 Total Return
Information Technology41.4%
Consumer Discretionary28.8%
Health Care26.7%
Consumer Staples15.3%

Source: Bloomberg, 12/31/17. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Finally, there’s the fact that the last two market corrections (in mid 2015 and early 2016) were relatively mild and quickly erased by rapid bouncebacks in prices. Significant pullbacks are hardly unusual in stocks; looking long-term, they deserve their reputation for volatility, with the average period between corrections a mere 12 months.  Recent patterns of performance are simply odd by that standard.  Many investors simply have a gut feeling that there must be a day or reckoning coming, given that markets tend to revert to average over time.

Market corrections are commonplace


Source: Bloomberg, 11/15/17. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Low-vol strategies: don’t worry, be ready

None of this means US stocks are heading for disaster anytime soon.  Unemployment is high, inflation is subdued, the Fed is dovish – what’s not to like? Given the unprecedented arc of central bank policy since the financial crisis, one can argue that the usual assumptions don’t apply in the short term. 

Yet vague anxieties could become realities if today’s sunny assumptions are put to the test.  The most likely culprit would seem to be a too-fast shift in interest rates, based on a macro disruption no one sees coming or a miscalculation by the Fed in its policy implementation.  There’s also the possibility that the final tax package out of Washington undershoots expectations; that China’s debt-fueled growth slows as the government reins in lending; or the already contentious trade talks on Brexit and/or NAFTA take a nasty turn.

How to address these risks? Certainly not by fleeing the market and potentially missing out on future gains. The fact there hasn’t been a correction lately doesn’t mean a correction is going to happen tomorrow. But it will at some point, and it’s prudent to be prepared.

Hedging risk with options is one solution, but it comes with a significant price tag that can erode returns.  A better solution, and one that does not sacrifice exposure to the overall market, is a low volatility approach that focuses on stocks that have features that naturally work to dampen volatility -- namely a healthy dividend stream and a high-quality business that’s supportive of prices long-term.  

The key is to find a manager with a process that leverages insights about previous market activity along with forward-looking measures that seek to quantify current and future sources of risk. In the words of James Norman, President of QS Investors, which manages a range of low-volatility equity strategies: 

“While you want to be aware of what’s happened historically in periods of low volatility, it shouldn't be the only thing. In our view, it’s better to take an approach that’s also forward looking, that integrate factors that could impact future volatility, like dividend payouts or earnings.”



IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.