Among the indicators of rising unease among investors are soaring valuations of stocks with histories of low volatility. These stocks now, as a group, have a forward P/E ratio that is a record 45% higher than that for high volatility equities, according to Keith Parker, head of U.S. equity strategy at UBS Group. He believes that it is still too early in the economic cycle to pay such a large premium for these supposedly safer stocks, as reported by Business Insider. The table below presents recent performance data for two leading low volatility ETFs.
Low Volatility vs. the Market
Source: Yahoo Finance; changes in adjusted closing prices from 10/2/2018 to 1/17/2019.
Significance for Investors
As the table illustrates, low volatility stocks have beaten the market since the selloff that began in October 2018 for the S&P 500. However, during the correction that bottomed out in February 2018, both of the low volatility ETFs listed above posted losses of about 9%, not much better than the 10% decline registered by the S&P 500, Barron's reports.
The macro environment in February 2018 was generally unfavorable for low volatility stocks, given concerns about an overheating economy and soaring interest rates, Barron's adds. The opposite applies today, with signs instead of decelerating economic growth and diminished inflationary pressures. Indeed, the odds of a recession beginning in the near future are rising, Morgan Stanley warns.
Keith Parker of UBS believes that the current economic expansion could last into 2020. He notes that the ISM Manufacturing Index historically takes 26 months to bottom out after a peak, but the most recent top was only five months ago. He advises investors to stay overweight in growth sectors such as technology and health care, rather than shifting to defensive sectors such as consumer staples and utilities. He thinks that this alternative strategy "is still relatively cheap while still accounting for the key risks as it relates to tariffs, decelerating growth, rising wages, and [profit] margin sustainability," per a note to clients as quoted by BI.
Nonetheless, Parker has slashed his forecast for the S&P 500 in 2019 from a year-end value of 3,200 to one of 2,950, a cut of 7.8%. He also suggests that investors focus on high quality companies, including those that are able to increase their dividends at a faster pace than the market.
Meanwhile, five market indicators linked to volatility are flashing warning signs right now, based on a report in Bloomberg. In some of these cases, low volatility may represent the calm before an approaching storm.
In six large market pullbacks from 1998 through 2015, low volatility stocks had smaller declines than the S&P 500 as a whole, per another Barron's report. Also, the S&P 500 Low Volatility Index outperformed the S&P 500 by an average of about 90 basis points per year across the last 20 years, per that same article.
However, during the most recent 10 years, which largely coincide with the current bull market, the broader S&P 500 did better by an average of 176 basis points per year, according to S&P Dow Jones Indices. If the market does indeed tumble again, and if history is a guide, the strategy recommended by UBS may prove to be risky, while a move to low volatility stocks may be an appropriate defensive measure.