- Mon, Jan 9, 2012
Macro Focus: Keeping Your Cool in Volatile Markets
The wild stock market volatility of 2011 has been difficult for many long-term investors to stomach. It would be a mistake, however, to overreact. Volatility in and of itself does not automatically foretell a downtrend in the market. Using history as our guide, the sharp volatility will likely ease at some capricious point, and provides investment opportunities in the interim.
Understanding volatility: the VIX
The most widely watched measure of stock market volatility is the VIX index. It is commonly referred to as “the fear gauge” but actually is a mathematical calculation of expected changes in the S&P 500 index over the next 30 days. The equation is based on the call and put option premiums for S&P 500 contracts reflecting the price traders are willing to pay for the opportunity to benefit from a potential swing in the market in either direction. Although call options premiums are in the calculation just as much as put premiums, it is the puts that drive the index. This is because traders are more inclined to pay high prices to bet on a swift plunge in the stock market than they are on a sharp spike upward. Thus, the VIX tends to rise when fears of a market downturn increase, which typically occurs after a market rout.
Long-term fundamentals
The imperative method in investing is to develop a strategy based on sturdy long-term fundamentals and to stick with that strategy. Numerous studies have validated this approach, specifically a recent DALBAR examination, which demonstrated that investors are their own worst enemies. Precisely speaking, in the 20 year period through 2009 the S&P 500 returned 8.2% per annum while the average mutual fund investor logged only 3.17%. The variance suggests that investors have chronic bad-timing when it comes to stocks and the volatility that persuades them to sell. To react to every headline out of Europe, China, or every media-soaked decree that the U.S. economy has entered a double-dip recession because of a couple of bad economic numbers will not only drive an investor crazy, but will also probably lead to some very poor decisions.
Present fundamentals are reasonably good in the U.S. Indeed, the economy is demonstrating solid trends as evidenced by recent employment data, retail sales, consumer sentiment, industrial output, corporate financial health and profitability. Perhaps most importantly, stocks hold significant relative value, especially when viewed through the calculus of the Fed Model [relative value vs. government bonds].
Earnings growth in the third quarter was almost 18%, with the previous two quarters resounding similar rates [19.7% and 19.2%, respectively]. Current estimates for the fourth quarter expect a 5% increase. For this year [FY2012], the rate is expected to clock in at 8% – admittedly a sharp decline from the double-digit growth since the recession ended, but still a spirited clip. At a current TTM multiple of 13 and forward multiple [if the E holds up in 2012] of 12, the market’s current quotation holds attractive value.
The alternative to this equity landscape, in conjunction with an S&P dividend yield of over 2% with rising dividends, is a locked-in diminutive 1.9% on a 10-year government note. With a yield like that, you’re not even keeping up with present-day inflation.
Safety in stocks.
There is always risk to owning stocks. It is no secret that stock prices can go down. Yet, there is a great deal of variance between the two ends of the stock market risk spectrum. In light of the global tail-risks and the ensuing market volatility, investments in high-quality, high-dividend yield, multinational companies offer reasonable dampening to the downside while paying you a juicy dividend while you wait. To be sure, many of these stocks are actually quite low risk. We find an abundance of these stocks across the utility, health care, consumer staples and telecom complex, although they are not limited to just these sectors.
A number of these stocks actually sport credit ratings of AAA, higher than the U.S. government after this summer’s S&P downgrade, while providing a greater yield than the 10-year Treasury note. Nearly all sport rising profits, and have boosted their dividend every year for many decades. While many of these companies have exposure to Europe and earnings growth will indisputably be constrained in that region for the foreseeable future by what could be a stagnant European economy, that, in our view, is well recognized by the market. Indeed, a great deal of the risk appears priced into many of these stocks.
Perhaps most relevant for those concerned with volatility, these stocks are also far more stable than the market in general. In market speak, they have low betas. Make no mistake, in a true “risk-off” climate most of these stocks will get caught in a downdraft that’s affecting the overall market, but far less so than many other stocks. When these strong dividend-payers get pulled down by overall volatility, it often represents just another excellent entry point for long-term investors. Their compelling dividends, stable business models and defensive moneyflows typically provide reasonable price floors when the market is falling.
Bottomline.
The recent swings in the market do not have to unsettle your life or your portfolio. Naturally, keeping abreast of the developments out of Europe is certainly vital to near-term market strategy as this tail risk represents the biggest sword currently hanging over the global economy. More important still is understanding the implications of the various scenarios and corresponding probabilities. What we see as critical right now is that Europe is addressing its problems — there finally appears to be a sense of recognition to the challenges laid out before them, to which fiscal remedies are being administered while its central bank [ECB] provides the liquidity needed [via new lending programs] to side-step global financial turmoil. That said, there isn’t a panacea for all of Europe’s issues. They won’t be solved right away; it may even get worse before it gets better. Either way, the issues in the region likely present a long and unpredictable slog ahead.
Therefore, taking a longer-term view for your longer-term investments is a winning strategy. Turn off the TV, the sensationalized online media and pundit opinions. Keep the 2-3% market swings on the latest rumor out of Europe in perspective. Stay the course with a sound investment policy, a cogent asset-strategy to execute that policy, and a portion of your portfolio in high-quality dividend paying stocks. Oh, and keep collecting those dividend cash streams.
Jason Ware
Market Strategist, Analyst
(801) 487-3700; (877) 487-6200
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