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Market Outlook

Sector Rotation and Our Low-Volatility Concerns

By Elliott H. Gue, on Sep. 14, 2017

Our breakdown of the market’s low volatility won’t be new to Capitalist Times Premium subscribers. But we thought other readers might appreciate the excerpt from one of our recent portfolio updates. If you aren’t a subscriber, do so now and read our investment advice as soon as it’s published.

The S&P Volatility Index (VIX) is a measure of volatility priced into S&P Index options.

The VIX typically spikes when the market sells off to reflect increased demand and cost of put options used to protect investors against a broader market decline. In contrast, when the market rallies and investors are sanguine about the future, demand for these options–and the price traders must pay to buy them–tends to decline, keeping the VIX relatively low and range bound.

Since periods of heightened fear tend to coincide with major market lows, there’s an adage: When the VIX is high, it’s time to buy. And, over time, spikes in the VIX have proved good buy signals for long-term investors.

This year has been remarkable for its unprecedented lack of volatility. Over the past 6,957 trading days (data going back to January 1990), the VIX has closed below 10 on only 27 occasions and a whopping 18 of those trading days have been in 2017. It’s fair to say that never in the history of the VIX have investors witnessed so little fear and volatility priced into the S&P Index options market.

(Click to enlarge.)

There are several possible explanations for the extraordinary depressed reading on the VIX this year. Some argue it reflects the activity of low volatility quantitative strategies–trading stocks with below-average volatility.

Such strategies have gained in popularity in recent years as several academic studies suggest that low volatility stocks have equaled the performance of the S&P 500 over the long haul. On Wall Street, the concepts of risk and volatility are roughly equivalent. As a result, buying low volatility stocks and earning a near-benchmark return represents every investor’s dream­–high returns with low risk.

Another explanation is the action of global central banks in response to the 2007-09 financial crisis and Great Recession. The Federal Reserve, European Central Bank and Bank of Japan, among others, have flooded global markets with liquidity in recent years to drive down borrowing costs and stimulate economic growth. One notable side effect has been inflation in asset prices including stocks, bonds, real estate and even art.

Since the rising tide of liquidity is lifting all boats, it’s depressing and obfuscating normal market relationships, volatility and fear.

Still a third explanation is that the rising popularity of passively managed index funds has been driving stocks–particularly large-cap stocks that have hefty weights in the broader market indexes–higher regardless of underlying fundamental prospects. This certainly explains why stocks like Amazon.com (NSDQ: AMZN) trade at historically inflated valuations over 200 times earnings and continue to lead the market higher.

We’ve even read a few articles lately discussing the death of traditional value investing and valuation metrics in this new era of markets driven by passive investment flows.

In times like this, we’re reminded of the most expensive words in the financial markets: “This time it’s different.”

While it’s likely that all the factors we’ve just outlined have dampened volatility and driven up stocks, experience and history suggest the underlying forces of human nature, investor psychology and economic fundamentals are every bit as powerful today as they were a decade or even a century ago.

Ultimately, this period of ultra-low volatility will give way to heightened fear and, at the very least, a market correction that will see the S&P 500 pull back on the order of 5 to 10 percent. Longer term, the flaws of some of today’s most popular trading and investment strategies will become apparent. Past examples of “forever” strategies include the so-called “Nifty Fifty” era of the 1960s and 1970s, which ended in disaster, and the popular “Portfolio Insurance” strategies following the crash of 1987.

The market’s current addiction to a low-volatility drift higher raises broader concerns. As we noted earlier, Wall Street tends to equate risk and volatility. Viewed in that light, today’s prolonged stretch of low volatility means that risks are low and these strategies can borrow money to lever up their returns.

That begs the question: What happens when volatility spikes, as it always has since the dawn of financial history?

Our concern is that all of the leveraged portfolios using this low-volatility strategy will have to de-risk as a herd by selling stocks. The result could be a sharp and dangerous cascade lower.

Predicting market crashes is folly, because it’s always tough to get the timing right. However, there’s a heightened probability of scary sell-offs before the end of the year, likely led by the same stocks that have driven the market higher in 2017.

That’s why we’re retaining our recommended hedge in the ProShares Short QQQ (PSQ) exchange traded fund (ETF) in the Wealth Builders Portfolio. And it’s despite the Nasdaq logging a marginal new high in late July before seeing renewed weakness.

Rotation, Rotation, Rotation

While the risks of today’s low-volatility stock market are clear, we continue to believe the next sell-off in the broader market will be a correction, not the beginning of a new bear market.

Historically, bear markets for the S&P 500 rarely precede recessions by more than 12 months. And, while US economic growth remains subdued, activity in the US and Europe appears to be picking up, not slowing down. That leads us to believe that any US recession is likely a 2019 event, at the earliest.

Moreover, bull markets tend to end in euphoria, not fear. Historically, the final 12 to 24 months of bull markets in the S&P 500 offer the most dramatic returns of the entire cycle. Missing out on that final melt-up has been a painful experience.

However, look for a rotation out of the growth-oriented fare that’s led the market for much of 2017 and into cyclical and value groups including the financials, energy and industrial stocks.

Capitalist Times Premium subscribers may continue the article and our analysis of a recent Portfolio addition by reading Low Volatility, Heightened Concern.

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