A shift from buying large U.S. stocks indiscriminately to favoring those with the best earnings prospects is the reason volatility is so tame, but don’t expect it to last, said Nick Colas, chief market strategist at Convergex, a global brokerage company based in New York.
Implied volatility measured by the CBOE Volatility Index VIX, -1.89% dropped to the lowest level since 1993 earlier this week. On Friday it was down 1.8% to 10.40, well below the historical average of 20. Meanwhile, the S&P 500 VIX, -1.89% closed at 2,330.90, less than 1% below its record close and is up 6.7% year to date.
For investors, this is good news. Record-low volatility, after all, means no big heartache from negative returns in the short term. In fact, correlations between assets tend to rise during bear markets and panics. Assets tend to be positively correlated—or move in the same direction at the same time—when markets are panicked.
Very low volatility over a protracted period, however, isn’t ideal for investors going forward, as future long-term returns are likely to be lower.
“Historically, very low levels of volatility are followed by very high levels of volatility. Volatility tends to drop to lows at market peaks. This also fits neatly with the notion that stocks at high valuations have lower long-term returns,” Colas said.
Based on one widely followed measure of equity values, cyclically-adjusted price-to-earnings ratio, known as CAPE and developed by Yale’s Robert Shiller, is at 29 currently. Its historical average is about 16, suggesting that stocks are pricey.
“While 5-year average returns on the S&P 500 will likely be in mid-single digits, the actual journey over the next five years could be extremely volatile—with large drawdowns followed by sharp recoveries that eventually average out as mediocre returns,” Colas said.
In the short term, big differences in performance of various sectors might provide excellent returns if you are able to pick the right investments.
For example, had you invested just in technology stocks over the past 12 months, your return would be 36%, more than double the S&P 500’s return over the same period. The 12-month return of telecoms is negative 6.7%. Energy shares, which advanced 24% in 2016, are flat over the past 12 month, after giving up most of their returns due to weakness in crude-oil prices CLM7, -0.02%
“Which is why holding the entire stock market is still a better option for many investors,” he added.