Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The Fed announced yesterday that it plans to extend Operation Twist, but probably disappointed a lot of investors who expected QE3. What are your initial thoughts on the Fed’s move?
Stovall: My initial thought was that the Fed did as S&P Economics expected it to do, which was to not engage in QE3 and extend Operation Twist for either three months to possibly six months. However, while the markets may have been a bit disappointed that they did not get QE3, they were probably also disappointed that the amount of the new Twist–$267 billion through year end–was a bit smaller than what had been expected. Although, when you think about the range of possible statements from something as aggressive a new form of QE3, to extending Operation Twist, to doing nothing but simply remaining vigilant, investors ended up getting something in the middle of the road.
I think the reason why the Fed did say what it did is because the U.S. economy, while having slowed since the April statement, is still on an upward trajectory. we’re not at a risk of falling off an economic cliff. The headwinds in Europe have diminished a little bit with the election of Greek leaders who are likely to continue to embrace the previously agreed upon austerity plan. Also, the inflation rate in the U.S. at 2 percent, while low, is still at the upper limit of the Fed’s preference zone. Certainly, the Fed has left the door open, but right now, investors probably should be happy with what they got.
EQ: Last week, you mentioned that investors may be wondering if the Fed is running out of silver bullets in regards to stimulating the economy. Also, the impact of further stimulus has been shown to diminish with each new plan. Does withholding QE3 help to at least maintain the appearance that the Fed can still do more if it needed to?
Stovall: That’s an interesting way of looking at it. It’s almost like the old saying of, “It’s better to keep your mouth shut and appear stupid, than to open it and remove all doubt.” So in this case, by the Fed not doing something, it makes investors feel a little bit better that they still have something in their pocket they could take out and use to help stimulate the economy, even though maybe it really won’t be enough to do what needs to be done. I think what needs to be done is to have Congress and the President agree on a budget and change in tax policy, and basically look to make fiscal decisions that extend beyond a three-to-six month time horizon. A lot of businesses and a lot of consumers are not very willing to make long-term commitments–either to plant and equipment, or to portfolios–if they are totally unsure of the tax consequences. Why would investors go into high-yielding stocks at this point while interest rates are low, only to possibly see the tax rate move up beyond 40 percent? The Fed could do only what it can do, but I don’t believe it’s going to be enough on its own to pull this economy out of a very slow upward trajectory.
EQ: In this week’s Sector Watch report, you said that bond yields and stock prices are playing a game of chicken. Can you discuss this?
Stovall: I examined the rolling spread between the 10-year constant maturity Treasury bond as well as the average yield on investment-grade bonds. Whenever that yield spread spikes, meaning that the difference between treasuries and corporate bonds widen, and depending on how high that spread goes, then usually it’s an indication of investor concern, fear or panic. Right now, at 3.65 percent, it is well above the average of 1.97 percent dating back to 1962. Where we are right now is also well above one standard deviation from the mean, and is close to two, so we are certainly in an area of extreme. Usually, areas of extreme tend to forecast something will happen fairly soon.
Also, when you look at the S&P 500’s price performance, whenever the yield spread spikes higher then stock prices tend to slump lower. The reason being that as fear picks up for bond investors it usually coincides with a decline in equity prices because investors are worried about the health of the global economy. So with this bond spread being almost twice the average, yet stock prices have been advancing, my feeling is that something has to give. Either the bond investors are overestimating the risks in the global market place or equity investors are underestimating the risk. Right now, I tend to believe equity prices probably need to go through at least some sort of digestion of recent gains. S&P Capital IQ’s chief technician, Mark Arbeter, believes that we have recently bumped against very formidable resistance at the 1360 level on the S&P 500, and he believes we probably would at least be going through some sort of digestion of these gains. From there we will have to reevaluate whether the move we just saw was a countertrend rally or the beginning of a full recovery of this recent pullback.
EQ: You also looked at several Low Volatility Indices as compared with their broader counterparts. Surprisingly, the low volatility indices outperformed their benchmarks. Why do you think that is?
Stovall: A rising tide lifts all boats, and in an advancing market place where stocks in general are rising, high-beta stocks do very well and low volatility issues also do well because they get dragged along with the higher beta stocks. Yet, you could almost say that with low volatility investing, boring is beautiful. In this secular bear market that we have experienced since the turn of the millennium, the S&P 500 on has maintained a negative price performance from 1999 through the end of May 2012 on a cumulative basis. What’s interesting is the low volatility indices–those with the lowest trailing 12-month standard deviation–also have relatively high dividend yields, and as a result, their total return of 3.6 percent over the last five years compares quite favorably to the total return of -0.9 percent for the S&P 500.
Internationally, we also have the S&P Developed International Low Volatility Index as well as an S&P Emerging Markets Low Volatility Index. At the same time, in the spirit of full disclosure, we’re not the only ones to offer low volatility indices because I guess the most sincere form of flattery is imitation. As a result, MSCI also has a low volatility index for its EAFE Index, as well a low volatility index for its emerging markets areas. So around the globe, investors can very easily find low volatility opportunities in which to invest. So despite volatile markets, investors are now not forced to ride the rollercoaster, they can alternatively enjoy the merry-go-round.
EQ: What are some low volatility ETFs that investors can consider?
Stovall: investors have a wide variety of ETFs that they can invest in to embrace this low volatility strategy. The biggest one out there is the S&P 500 Low Volatility Index (SPLV), but there’s also the S&P International Developed Low Volatility Index (IDLV) and the S&P Emerging Markets Low Volatility Index (EELV) as well. For MSCI EAFE indices, there is the Minimum Volatility Index (EFAV) and the World Minimum Volatility Index (ACWV).
One word of caution, however. Investors need to make sure they are aware of the trading volumes. The trading volume is very large for the SPLV but relatively small for the IDLV and EELV. We also have a similar situation with a wide bid-ask spread for the non-U.S. low volatility indices, both for S&P and MSCI. So just make sure you realize that some days you might simply be trading against yourself.