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A volatile October is spooking investors. But are they merely afraid of their own shadow?
“We have been spoiled for the better part of 2 1/2 years with very little volatility,” said Hank Smith, co-chief investment officer at Haverford Trust, with $7.6 billion in assets under management.
A wild week that saw the Dow Jones Industrial Average DJIA, -1.19% tumble 600 points on Wednesday, reclaim much of it on Thursday and end the week with stocks suffering another sharp fall — and plenty of big swings in between — was unsettling for many investors.
But to Smith’s point, investors might be facing a bit of a readjustment process after long stretches of relative market calm. The past week’s market rout left the S&P 500 SPX, -1.73% 8% below its all-time closing high from Oct. 3 and on the doorstep of a market correction, while the Nasdaq Composite COMP, -2.06% did tumble into correction territory, generally defined as a pullback of 10%. The S&P, of course, fell into correction as recently as February before eventually climbing out to begin a run to new highs.
Before that, stocks saw some rough sledding in 2015 and early 2016, but had seen relatively little in the way of major pullbacks for several years.
Nonetheless, it’s no surprise to see big swings prompting nervous investors to want to cut down on their exposure to the volatility, analysts said. And that’s drummed up interest in certain strategies.
Analysts at Pavilion argued in a Thursday note that of two popular choices in the hunt for safety, low-volatility strategies might be a better bet than quality.
The S&P 500 low-volatility index, which picks the 100 names in the benchmark with the lowest realized volatility, has broadly outperformed the broader index since 2010 with few exceptions, they noted, but has seen weaker relative performance in 2018 despite recurring bouts of market turmoil.
That’s because quality stocks, which are usually defined as offering a high return on equity, low debt-to-equity and low volatility of earnings per share, have outperformed the S&P 500 while offering a good proxy for low volatility, the strategists said.
But while both strategies have flaws, quality might suffer a distinct disadvantage in the current environment because its large weighting in tech, consumer services and consumer discretionary shares has left it more positively correlated with momentum, “which isn’t very appealing when stocks are selling off,” they wrote.
Low volatility, by contrast, is less correlated with momentum and more correlated with value.
Smith, in a phone interview, said Haverford has stuck with a strategy of balancing portfolios between “offense,” featuring cyclical sectors like materials, industrials and tech, and “defense,” including sectors like consumer staples and health care.
Meanwhile, there is likely opportunity in some “high-quality” names that have been sharply oversold, he said, such as DowDuPont Inc. DWDP, -1.74% down 19% in October, and JPMorgan Chase & Co. JPM, -1.37% —“the highest quality bank in the world.”
In addition, dividend-paying stocks are looking attractive again after the October selloff, allowing investors to pick up yield without having to sacrifice quality, he said. “I would still rather get 3% from a high-quality equity in which I’m reasonably assured I’m going to get dividend increases…than 3% on a 10-year Treasury.”
The past week saw a massive run of earnings, which often appeared to add to the volatility. So far, 48% of S&P 500 companies have reported results for the third quarter, according to FactSet.
The percentage of companies reporting actual earnings per share above estimates (77%) is above the five-year average, according to FactSet’s John Butters. In aggregate, companies are reporting earnings that are 6.5% above the estimates, which is also above the five-year average, he said.
In terms of sales, the percentage of companies reporting sales above estimates (59%) is equal to the five-year average, Butters found. In aggregate, companies are reporting sales that are 0.8% above estimates, which is slightly above the five-year average. The week ahead brings results from 139 S&P 500 companies including six Dow components.
On the data front, the highlight will likely come Friday with the October jobs report. Analysts surveyed by MarketWatch look for payrolls to rise by 200,000 after a gain of 134,000 jobs in September. The unemployment rate is forecast to remain at 3.7%.
