Low Volatility Not All Bad

10/16/2017


Even Nobel Prize winners are having a hard time explaining the stock market's unusually low volatility.

"We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it." That's what University of Chicago professor Richard Thaler, recently awarded the Nobel Prize in economics, told Bloomberg TV on Oct. 10.

The S&P 500 Index has gone more than 335 trading days without a 5% drop, surpassing a record set in 1994. Last month was the least volatile September in 66 years, and volatility so far this month has been the lowest on record for October going back to 1928. The CBOE Volatility Index, based on the expected volatility implied in option prices, recently hit its lowest level since 1993.

Some argue the low volatility is a symptom of investor complacency. Others say that new trading vehicles have made it too easy to bet on continued low volatility — and that even a modest market pullback could trigger a spike in volatility as these trades are unwound.

While these are valid concerns, not all the factors suppressing volatility are bearish. For example:

• Correlations among individual stocks are unusually low, meaning volatility in the indexes is being dampened by stocks moving in different directions. Implied correlations, derived based on the differences in option prices for individual stocks and the S&P 500 Index, are near 20-year lows.

• Based on mutual-fund inflows, this has been one of the least loved bull markets of the past 30 years. Now, with sentiment improved and many still underexposed to stocks, investors embrace even minor pullbacks as buying opportunities.

• Stock-market volatility tends to come with economic volatility, and U.S. growth has been unusually steady in recent years. So have U.S. bond yields and inflation. The risk of a near-term U.S. recession is low, partly because overseas growth has improved.

• Politics, terrorism, and international conflicts matter to investors to the extent they impact corporate earnings, and those threats have had little impact on the favorable backdrop for U.S. profits. Improving revenue growth, still-modest wage pressures, a lower dollar, and improving commodity prices all bode well for U.S. earnings.

Conclusion

With September-quarter reporting season imminent, investors' confidence in the earnings outlook will be tested in coming weeks. Subscribers should look for buying and selling opportunities on a stock-by-stock basis while maintaining a nearly fully invested posture. Our Focus List and Buy List have 100% in stocks, while our Long-Term Buy List has 94%.


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