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Market Volatility – “A Few Minutes with Marcia”

Volatility measures the frequency and magnitude of price movements, both up and down, that a financial instrument experiences over a certain period of time. The more dramatic the price swings, the higher the level of volatility.

Learn the basics of market volatility with Marcia Clark, CFA, MBA.

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For those who prefer to read!

Welcome to A Few Minutes with Marcia. My name is Marcia Clark, Senior Research Analyst at Warren Street Wealth Advisors. Today we’re going to talk about the 4th quarter 2018 stock market dive and 1st quarter 2019 rebound in an attempt to understand more about market volatility.

Prior to 2018, the stock market had experienced 2 years of unusually low volatility, despite a few bumps along the way. After a mixed start to 2018, the Dow Jones Industrial Average looked like it was back to its winning ways, then came the 4th quarter tumble. Investors were caught by surprise by the huge swings in market prices – volatility – and started selling stocks like crazy. To better understand these market dynamics, let’s put the recent activity into context.

You may have heard of a common measure of market volatility called the ‘VIX’ – the Chicago Board Options Exchange volatility index. The VIX measures expected future volatility by evaluating the prices of put and call options traded on the exchange. If you’re looking at the slideshow, you can see how much calmer the VIX index was during the quiet years of the stock market, especially in 2017. As the market swooped up in late 2017, expected future volatility spiked shortly thereafter – remember that volatility can spike when prices go up as well as down.

When the market gave back some of its gains in early 2018, the volatility index fell back as well. Then came the market tumble in late 2018. The VIX index starts jumping around like a Richter scale during an earthquake. As we move into 2019, even with the recent pick up in volatility the graph shows that the VIX is at a pretty normal level compared to prior years. We’re just not used to ‘normal’ volatility anymore.

Where do we go from here? No one knows for sure, and if anyone says they can predict the future they’re kidding themselves and their clients. What we can say is that financial markets react to rumors and headlines, many of which don’t fundamentally change the financial landscape. This ‘knee jerk’ reaction causes market volatility, and this volatility is normal. In fact, active investment managers appreciate market volatility, because market dips based on headlines rather than fundamental changes in the economic landscape give investors with a strong stomach and an evidence-based outlook the ability to buy good assets at cheap prices. If all goes well, those assets will recover their value plus more over time, and patient investors will be rewarded.

 

Marcia Clark, CFA, MBA
Senior Research Analyst
Warren Street Wealth Advisors

Warren Street Wealth Advisors, a Registered Investment Advisor. The information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the strategies or options presented. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. 

 

 

DISCLOSURES

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications.

Form ADV available upon request 714-876-6200

Marketing the Safety Out of It

A growing theme in investing is to target and invest only in the least volatile stocks in the market. One simple example of this is take the S&P500, which is a representation of the 500 largest publicly traded stocks in the United States, and only invest in the 10% of companies with the lowest standard deviation of the 500. This would produce names such as AT&T, Coca-Cola, and Johnson & Johnson. 

This simple concept traditionally would result in an investor owning a lot more safety, blue chip, and high dividend yielding stocks. Not a bad bet in a historic context. Looking forward however, we have an accelerating concern over the price of these types of companies, which may lead to them not being as safe as one would expect.

One metric we look at to value stocks is the Price to Earnings ratio, the easiest way to describe this is what price is an investor willing to pay for every dollar a company earns in profit? A higher P/E ratio implies more expensive,  a lower one implies cheap. Comparing a stock, or an index, such as the S&P500 to its historical average P/E can give you a relative idea of whether something is expensive or cheap compared to historical  standards.
Historically, going back to 1972, the companies in the lowest 10% volatility bucket in the S&P500 (as measured by standard deviation) produce a historical median P/E ratio of roughly 13. As is stands today that same low volatility class of stocks trades between a P/E ratio of 23 to 24.

Low Vol Record PEChart provided by Ned Davis Research, Inc.

Why is this troubling? Well, when prices revert to the mean, and investors are willing to pay less for those same dollars of earnings, it spells trouble for those who hold these assets, especially those who have been chasing the stability and dividends these stocks were expected to provide.

What is causing this? Let’s take a look at the major contributors:

Fed policy. While artificially low interest rate policy is intended to push investors into riskier assets, some investors still want safer assets. Low volatility stocks have higher dividend yields, making them bond proxies.

Sector attribution. The low volatility group is concentrated in Utilities, Financials, and Consumer Staples, which have high dividend yields and P/E ratios that are above their long-term averages.

High valuations for the broad market. The median P/E for the S&P 500 is 24.0, well above its historical norm, which has pushed investors into “safer” stocks.

Secular trends. Fear is a stronger emotion than greed, so investors have flocked to “safer” assets.

Industry innovation. ETFs have enabled investors to more easily buy themes like low volatility.

The first three factors are the most likely the first ones to threaten this crowded trade. The one that has me the most troubled is the fifth factor. Industry innovation has led to specialized investment products that make it very simple for retail investors to buy into this wave of low or minimum volatility assets. We’re seeing these assets recommended in droves to competitor’s clients, with little to no consideration given to how crowded or expensive the trade may be.

These assets in the broad context of a well diversified portfolio may make sense, but from my perspective every asset has a time and a place. Currently, I would not be overpaying for safety by using these low volatility factors we’ve explored above. There are other ways. Like always, when assets deviate from a historical valuation range, it can take quite awhile to be proven right and see them correct. We’re not yelling fire in a crowded theater but would like to see investors better educated on the risks ahead.

 

Thank you for reading!

Blake Street
Written by: Blake Street, CFA®, CFP®, Chief Investment Officer

Blake Street is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information posted here represents his opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional.  Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.