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The market will digest the latest twist in the ongoing Greek bailout saga this week, Janet Yellen’s semiannual testimony before Congress on the economy and monetary policy, and a series of earnings reports including several of the major banks.  Our comments this week focus on how higher volatility shares reflect changed investor attitudes regarding risk in recent years.

Macro View

While the return of a risk-taking attitude is helpful for the economy to grow, we are mindful that there is an eventual limit to the amount of risk that markets will ultimately be willing to assume.  Increasing risk tolerance can be seen in the leadership of higher risk stocks since 2012 — just prior to the start of the Fed’s latest round of asset purchases (chart below).  Since then, some investors have migrated toward higher risk securities in search of added return.  This can, however, introduce unwanted risk into a portfolio.

Increasing Risk Appetite Driving “Higher Volatility” Stocks S&P 500 High Beta, S&P 500 Low Volatility, and S&P 500 Indices 2012-2015 (Growth of $1)

hig-low-beta

Source:  Bloomberg Data

We are reminded that the stock “market” is actually comprised of many different kinds of stocks.  Companies with higher “torque” often tend to be associated with more variable earnings streams and higher degrees of leverage.  Lower volatility companies tend to be the opposite.  We believe now is time to take a second look at lower “torque” companies with less leverage and greater consistency.  Another tactic is to make sure that your portfolio allocation has not accidentally drifted too far into riskier securities as their prices have risen.

A longer perspective reveals that the tortoise actually did outrun the hare after all, especially after accounting for volatility (table below).  In our view, the lion’s share of the QE-induced pickup in risk appetite is now behind us.  This does not mean the bull market is over.  It just means that, given the outsized run by more highly “torqued” segments of the market, it might make sense to revisit risk controls, measures of company quality, and diversification principles.  Now is the time to focus on quality and diversification.

Longer-Run Returns (Since 1990) By Volatility Category

      ————-  Annualized   ———–
Category Return RISK RETURN/RISK
S&P 500 High Volatility 9.9% 23.9% 0.4
S&P 500 Low Volatility 11.0% 9.4% 1.2
S&P 500 7.9% 12.3% 0.6

Source:  Bloomberg, WCA Calculations

Earnings Update

Earnings are expected to decline by 4.4% for the second quarter versus the same period a year ago as decent growth in the United States is being offset by China and slow growth in Europe.  Lower commodity prices will again weigh on commodity driven companies.  Revenue is expected to account for most of that decline as revenue for the S&P 500 is expected to decline 4.2%.  Again, energy and materials companies account for a significant portion of the drag on results.  On the bright side, margins are expected to pick up through the back half of 2015 with S&P 500 net profit margins moving from 10.2% in Q2 to 10.6% by Q4.  The trailing 12-month net margin has been slipping and now stands at 9.7% compared with a 10-year average margin of 8.7%.  This trend would need to reverse in order to avoid margin misses and disappointments later this year.

There are 42 companies reporting this week which will bring the total number of companies reporting to 66 (13% of the S&P 500) by the end of the week.  At present, the forecast 12-month EPS estimate is $126.99.  At 16.3 times forward earnings, the S&P 500 trades at roughly a 15% premium compared to the 10-year average multiple.

Asset Allocation Portfolio Posture

LONG-RUN STRATEGIC POSTURE:  Strategic allocations are set to reflect our long-run forecasts for key asset classes.  We expect policy rates to remain low as central banks continue to push lower-for-longer rate strategies.  Eventually, rates should rise back to more normal levels, but this is expected to happen gradually and unevenly.  Fixed income returns are expected to lag current yields as rates rise.  Equity returns will track moderate growth in global GDP with little to no further lift from margin expansion (margins are already elevated).  Equity valuations appear reasonable and in line with historic multiples, so no additional return is being attributed to margin expansion.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.

Kevin Caron, Portfolio Manager
Chad Morganlander, Portfolio Manager
Matthew Battipaglia, Analyst
Suzanne Ashley, Junior Analyst

 

Disclaimer

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Indices are unmanaged, and you cannot invest directly in an index.