Stocks In 2019: Volatility Is Back

Volatility is back. It was easy to forget how downside pain in equities could feel given robust growth over the last decade—and especially the two years ending January 2018. Robust corporate profits and a benign interest rate environment meant that prices of risk assets climbed unabated with only mild, short-lived pullbacks. 

Headwinds for 2018 included a re-establishment of actual income and returns offered by the “risk-free” Treasury assets as the Federal Reserve (Fed) hiked rates, and fears over a global trade war were spiraling out of control. In our view, these issues are well known and increasingly priced into market valuations.

We will soon find ourselves a decade from the bear market lows of 2009, in one of the longest economic expansions since World War II. It is natural to worry about being late cycle in both the economy and the equity markets. Many are also worried that extended valuations imply poor forward returns. We are less concerned about the market generally, but there are pockets of caution—they just may not be where you’d expect.

In the fourth quarter of last year, there was a dramatic rotation away from momentum stocks—technology—toward more defensivedividend and lower-volatility stocks.

When our team evaluates valuations across common factors, low-volatility stocks across the United States look the most extended. The MSCI USA Minimum Volatility Index has P/E ratios that are a few points higher than the S&P 500, despite this segment of the market being concentrated in slower-growing, lower-profitability companies.

Despite volatility picking up and a natural desire to lower equity exposure, there is a hidden risk to this very popular and “crowded factor.” This “low-vol” factor performed the best in 2018, outperforming the market by over 500 basis points through mid-December. We’d be more cautious looking forward, despite the worries of rising volatility.

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