Are your clients ready for higher volatility?

Just as there is reversion to the mean in stock returns, there is reversion to the mean for stock volatility

Jan 12, 2018 @ 2:08 pm

By John Waggoner

If you have watched the market in the past 12 months or so, you may have noted a paucity of panic. A minimum of meltdowns. A deficit of drawdowns.

And that brings us to today's topic: Is that worrisome? If so, is there a rational way to reduce upcoming volatility spikes?

The market has been quieter than a mouse's muffler the past two years. The last day the Standard & Poor's 500 stock index fell more than 2% was September 9, 2016, when the blue-chip index tumbled 2.45%, said Howard Silverblatt, senior index analyst for S&P Dow Jones Indexes.

How unusual is this quietus?

"It's very unusual," said Sam Stovall, chief market strategist for CFRA. "In the past 12 months, we've only had eight days up or down 1% or more, while we had 62 all-time highs in 2017. That's twice the number of new highs than usual, combined with the second-lowest year in terms of volatility."

Just as there is reversion to the mean in stock returns, there is reversion to the mean for stock volatility — and the two often go hand in hand. Long stretches of low volatility and high returns tend to revert to stretches of high volatility and low returns, Mr. Stovall said.

"Historically, whenever we've had a year with such low volatility and so many all-time highs, the gain the following year was 5% with 50 days of above-1% volatility."

LPL Research had similar findings. In a recent client letter, they looked at years with some of the smallest intrayear pullbacks, and found that the average gain was nearly 26%. The next year, however, saw an average pullback of 12.1%, while the average number of 1% moves (closes either up or down 1%) spiked from under 13 to over 30. But the S&P 500 managed to gain a respectable 8.5% on average.

On the surface, low volatility seems surprising, given the many unusual and unsetting events of 2017. North Korea's nuclear program has advanced far more rapidly than U.S. intelligence thought: The country can now throw at least one nuke at the continental U.S., and that number will grow over the years. Trade relations between the U.S. and its partners are uncertain, to say the least.

On the other hand, Wall Street tends not to look at current events unless they have a direct bearing on earnings.

"Going back to the latter part of 2016, this has been a superb, broad-based and remarkably steady rally, based on optimism about global growth, increasing earnings and restrained inflation," said Terry Sandven, chief equity strategist at U.S. Bank Wealth Management. Hard to get too pessimistic with a backdrop like that.

What could turn up the volume on vol? A slowdown in earnings or a higher-than-expected rise in inflation, Mr. Sandven said.

"As we look further for volatility, we think the driver of it will be inflation," he said.

An uptick in inflation would lead to rising short-term interest rates as the Federal Reserve tightens monetary policy.

"We suspect that if the 10-year Treasury note yield gets to 3%, investors will have more interest in fixed-income securities," Mr. Sandven said.

The exchange-traded fund industry offers several ways to lower portfolio volatility. Ben Johnson, director of Global ETF Research at Morningstar Inc., suggests iShares Edge MSCI Min Vol USA ETF (USMV), PowerShares S&P 500 Low Volatility ETF (SPLV), Schwab US Dividend Equity ETF (SCHD) and Vanguard Dividend Appreciation ETF (VIG). The only drawback: Many of these ETFs are heavy in sectors such as real estate and utilities, which are already expensive. And, like bonds, they react to rising interest rates the same way Superman reacts to kryptonite.

A more direct way would be to invest in an ETF or ETN linked to volatility, such as iPath S&P 500 VIX Short-Term Futures ETN (VXX). At least so far, this has been an investment for people who don't really care how much money they have. Last year, the ETN lost 73% of its value — which followed a 68% loss in 2016, a 36% loss in 2015, a 26% loss in 2014, a 67% loss in 2013 and a 78% loss in 2012. Are you feeling lucky?

A better tactic would be twofold. First, remind your clients that someday, volatility will be back, and when it is, aggressive stock holdings will have some bad days. Remind your clients — and yourself — of how far off their goals are, and that aggressive holdings are best held for the long term. Volatility, after all, is one reason stocks earn more than bank CDs and Treasury bills.

A second would be to review portfolios to make sure they are close to the original asset allocations you had agreed on. Cash and bonds are the second-best cure for volatility. The best cure is a client who knows what she owns, and can ride out volatility on the downside as well as the upside.

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