Will Low Volatility Mean Lower Risk Next Time?

Well, it’s official. According to Ned Davis Research, this is now the longest period in history without the S&P 500 experiencing a correction of 3% or more. For those of you keeping score at home, NDR tells us that as of Monday’s close, it has now been 262 market days since the last time the S&P pulled back by at least 3%. The current run breaks the previous record of 256 days set back in 1995.

To put this feat into perspective, consider that since 1928, the S&P has experienced a correction of at least 3% every 22 trading days (or about once a month) on average. It is for this reason that pullbacks of 3% or more are often referred to as “garden variety” affairs.

In case you were wondering (I was), this is also the 4th longest period in history without a 5% correction, the 10th longest stretch without a 10% correction, and the 2nd longest span since early-1928 without a 20% correction (aka a “bear market”) for the S&P 500.

When these fun facts are added to the market’s lofty valuation levels – many of which are either near or above historic highs – it is little wonder that so many financial advisors are nervous about the outlook for the stock market these days.

Sure, the economy appears to be picking up steam. Yes, earnings are strong. It is true that rates are low and inflation doesn’t appear to be a threat. And no, the Fed isn’t likely to go on the war path anytime soon. Thus, it is fairly easy to argue that the market’s underlying fundamentals are pretty darn good.

Yet, investors and advisors alike remain nervous. The bottom line is nobody wants to get fooled again. No one ever wants to watch their 401K turn into a 201K the way they did during the crisis.

So, what have investors/advisors done to try and take less risk during this long bull run? From my seat, it appears they’ve plowed money into what have historically been lower risk plays such as high dividend paying companies and the so-called “low volatility” areas.

In fact, “low volatility” has become one of the popular factor-plays in stock picking. This is probably due to the fact that the low vol space has outperformed the broad market. According to PIMCO, the low volatility factor beat the CRSP/Compustat universe of U.S. stocks by 1.6% per year from 7/31/1968 through 6/30/2017.

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And as I’ve detailed in previous missives, the folks at BlackRock contend that focusing on the low volatility factor can reduce risk over time.

So, it is little wonder that investors who are nervous about the stock market would choose a low volatility approach.

The Fly in the Ointment

Such an approach has become very popular these days. Very, very popular.

So popular, in fact, that, according to PIMCO, the valuation measure for the low volatility factor currently resides in the 88th percentile.

As the chart below illustrates, the valuation level for the “low vol” factor is even higher (a lot higher) than the momentum factor – where the go-go stocks like the “FANGs” can be found.

(Click on image to enlarge)

In their research report dated November 2017, PIMCO suggests that “valuations matter” when considering factor investing. “An expensive starting point reduces future return prospects,” the report contends.

My point on this fine Tuesday morning is one needs to beware of crowded trades – especially when they reach extremes. In other words, if the bears were to find a reason to occupy Wall Street for a spell in the near future, those low volatility and high dividend plays may not provide the protection that is expected. I can even argue that the opposite might even occur if “the crowd” heads to the exits in these ETFs – all at the same time.

Is this a reason not to employ low volatility or high divy factors in portfolios? No, absolutely not. However, it is yet another good reason to diversify your investing approach in a modern fashion.

Thought For The Day:

The most rewarding things you do in life are often the ones that look like they cannot be done. -Arnold Palmer

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

    1. The State of Tax Reform

    2. The State of the Earnings Season

    3. The State of the Economy