Rising stock market volatility is no “sell” signal

Strategists are still finding value in equities as the bull ages; more advisers warming to real assets

By Jeff Benjamin

Apr 11, 2014 @ 11:18 am (Updated 1:32 pm) EST

Stock market, volatility, VIX, hedge fund, equities, quantitative easing
(Bloomberg News)

Just because volatility in the stock market has spiked and is likely to remain elevated, investors shouldn't be heading for the hills in a panic.

While 200-point plunges in the Dow Jones Industrial Average, such as the one on Thursday, will always draw attention, it's important to consider the context and accept a dose of reality.

“We started telling people at the beginning of the year that with the Fed reducing its quantitative easing, the market reins are being handed back to the market, and this is the kind of adjustments we can expect,” said Karyn Cavanaugh, senior market strategist at ING U.S. Investment Management.

Despite the increased level of daily market swings, Ms. Cavanaugh pointed out that stock market volatility, as measured by the S&P 500 Volatility Index is still below the average of the past 10 years. In fact, the VIX is currently around 15, which compares with an average of 20 since 2004.

For added perspective, the VIX spiked above 40 during both the height of the euro crisis in 2005 and immediately after the U.S. credit downgrade in August 2011.

“At 15 on the VIX, I wouldn't be too worried,” Ms. Cavanaugh said. “We're still in the midst of an economic expansion, so a stock that was good yesterday is still a good stock today.”

So far this year, the S&P's direction seems to have changed by the month, including a 3.5% decline in January, a 4.8% gain in February and a flat March. All told, the index is essentially flat year-to-date.

But if investors and by extension the markets, are rattled or even a bit confused, that doesn't fit with the data, according to Dick Burridge, co-founder and chief investment officer of RMB Capital, a wealth management firm with $4 billion under advisement.

“We think the economy right now is much stronger than investors are giving it credit for,” he said, citing improving data from the construction industry and auto industry, a pickup in consumer spending and rising consumer confidence.

(See also: Advisers warming to real assets as stock market volatility picks up)

“We're seeing positive GDP growth in Europe, Japan and the U.S. all at the same time for the first time since before the financial crisis,” he added.

Granted, with the S&P up about 170% since it bottomed during the financial crisis in March 2009, Mr. Burridge admits the market is probably due for a breather. Just not yet.

“We think we're in the third and final phase of the bull market, and we see markets at fair value right now,” he said. “And at fair-value levels, volatility increases because during this phase you will go from being fairly valued to being overvalued.”

But being overvalued is a legitimate part of the cycle and should be embraced.

“Every bull market dating back to the 1970s has peaked at premium valuations,” Mr. Burridge said. “I still think this bull market will last another couple of years, and will gain another 40% from here.”

Even putting the volatility into perspective doesn't always alleviate the anxiety of big market moves, as hedge fund manager Scott Wallace explained.

“This is the scariest 15 on the VIX I've seen in a long time,” said Mr. Wallace, founder of Shorepath Capital Management.

“There are a lot of things in the overall global stock and bond markets that are not explainable right now,” he added. “We just saw a massively oversold bond offering by Greece, where everyone suddenly wants to lend money at 6% to a country that was bankrupt two years ago.”

That kind of risk aversion, Mr. Wallace said, defies logic against the backdrop of such a broad stock market sell-off.

“I think what you have today is selling begetting more selling, and that's happening in the context of reasonably good economic news,” he said. “We're coming up on corporate earnings season, and I think as investors start to see the world isn't in such bad shape, we'll see things start to settle down.”

If nothing else, the latest bout of stock market volatility is helping to make the case once again for diversifying into assets that investors can actually touch and feel and whose prices don't move in lock-step with stocks.

Physical real estate, real estate investment trusts, and infrastructure master limited partnerships are the most common forms of the real assets that are starting to hit the radar screens of savvy financial advisers. Much like the broader alternative investments universe, real asset investments are becoming an increasingly popular go-to strategy for reducing portfolio volatility.

But there is room for more.

A study by Cohen & Steers Inc. estimates that 90% of advisers are already using real assets for their client portfolios. But they're only using real assets in 20% of their client base, according to the report, which was based on a survey of 660 financial advisers.

“It was a little surprising to us to find that among advisers using real assets, they are only using it in about one out of five of their client portfolios,” said Vince Childers, manager of the Cohen & Steers Real Asset Fund (RAPIX).

What's more, the research found that only 40% of advisers are treating real assets as a core holding, with the majority using the asset class for tactical purposes, which might not be the best strategy as performance data show that most real asset investments are more about non-correlated exposure than white-hot performance.

So far this year, for instance, real estate mutual funds tracked by Morningstar Inc. have gained an average of nearly 10%, which compares with a virtually flat S&P 500. Last year, when the S&P gained about 30%, the category rose just 2.3%.

Morningstar doesn't have a specific category for master-limited partnership funds, but a screen of funds with MLP in the name found that the average return this year was 2.8%. The MLP fund universe recorded an average gain of 24.4% last year.

“The main thing about real assets is you're getting the diversification of lower correlation to traditional assets, but you're also typically getting some inflation protection,” said James Cunnane, chief investment officer of the MLP and energy infrastructure team at Advisory Research Investment Inc.

Even with inflation in the U.S. at barely recognizable levels right now, the Federal Reserve Bank's unwinding of quantitative easing and the looming threat of higher interest rates make the case for real assets an increasingly logical argument.

“The longer-term attraction of real assets is definitely the inflation sensitivity, because with higher inflation you will be better off in real assets,” said Keith Black, managing director of curriculum and exams at the Chartered Alternative Investment Analyst Association.

“Another part of the attraction is that we're talking about real assets,” he added. “After the financial crisis, people realized that the stocks and bonds they owned were just paper assets.”