As Sam Sees It: Should Investors Shake Off the Recent Volatility?

Sam Stovall |

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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 US economy continues to chug along, to the extent that President Obama said that it was time to turn the page on the recession. Is it incorrect to categorize the US economy as being in recovery?

Stovall: I don’t think it’s incorrect. The US economy was deemed to have left the contraction and enter the expansion phase in June 2009, and with each successive quarter, we’ve been seeing an improvement of economic growth, a reduction of the unemployment levels, etc.

Obviously, knowing that you sometimes might get monthly or quarterly data that will surprise to the downside, I would tend to say that with the most recent GDP growth being as strong as it was and with the unemployment level now being well below the 6% threshold, a lot of economists today are assuming that we are underestimating economic growth rather than overestimating it.

As a result, somebody who says that the economy is not in recovery I think is not paying attention to the data.

EQ: While the US economy is one of the few areas of strength around the world, Europe is really starting to exhibit major shifts. The Swiss bank’s announcement to remove the cap on the franc/euro cap may be the biggest example of that right now. What are the potential implications there for US investors and companies?

Stovall: It’s not a surprise to say that Europe’s economic growth has been anemic and they are flirting with deflation. Both of which are situations that no central banker wants to be facing. The expectations of a fairly large injection of stimulus, along with further reduction of interest rates, is expected to be the tonic needed to increase economic activity and allow the European economy to move away from the deflationary precipice.

At the same time, however, rates will likely be moving lower in Europe, it’s going to make them even more unattractive to European investors. That could end up forcing them to the US, whose interest rates are substantially higher than what is found in Europe. As a result, we may end up seeing further strengthening of the US dollar, which could make overseas investments all the more challenging as the strength of the dollar eats away at the returns one would get from prices overseas.

EQ: As the companies with more global exposure become disadvantaged by this trend, would that attract more investor attention to companies that don’t have that exposure, such as small caps?

Stovall: That’s the general thought. A lot of large companies hedge their foreign currency exposure. As a result, they’re not at the mercy of the fluctuating dollar as you would think. Also, if what’s causing the US dollar is the attractiveness of US investments to overseas investors, these overseas investors are more likely to be gravitating toward the more liquid, more well-known names found in the large cap space than the much-less liquid and unknown names in the mid-cap and small-cap space.

So while small-cap stocks don’t have the international exposure, they also aren’t well known to the foreign investors. As a result, I think the foreign investors will stick with the names that they know as well as the liquidity that they need.

EQ: We’ve been expecting volatility to revert back to its historical averages for some time now. By that, meaning the average number of days the market moves up or down by over 1%. We didn’t necessarily get that in 2014. From what we’ve seen so far in 2015, do you expect that to finally happen?

Stovall: The fact that every day so far this year has experienced intraday volatility of 1% or more would lead me to believe that we could see a pickup for the entire year. Of course, there’s no guarantee that will happen.

Traditionally, as bull markets age we see an increase in the number of days in which that market goes up or down by 1% or more. With the seven year, which is what we’ll be entering come mid-March of this year, having averaged the second-highest number of 1% days. It is second only to the first year, and I think the reason why the market is so volatile the first year is because investors don’t really know we’re in the beginning of a new bull market, and are most likely worried that they’re simply being trapped into another phase of the old bear market.

So an increase in volatility is a natural occurrence and the way that 2015 is starting would imply, but not guarantee, that we could end up with an increase of volatility this year, possibly going from the 38 count we saw in 2014 to the 54 count we’ve averaged for all years going back to 1960.

EQ: So even if volatility increases from here, it could just be considered the markets getting back to normal?

Stovall: You could say that it’s not the new normal. The new normal is low volatility. The old normal is increased volatility.

EQ: If the old normal is still in play, you concluded in this week’s Sector Watch report that volatility isn’t a good predictor of the next major downturn. An extreme lack of volatility, however, usually does a better job of that. Are we in a period of extreme low volatility?

Stovall: We’re in a period of low volatility, and in the latter part of 2014, we got to the point of extremely low volatility. So from that analysis that I did going back to 2009, on a trailing 21-day basis, whenever we had three or fewer days that experienced volatility of 1% or more, it usually signaled that we will decline by 5% in the near term. So while this indicator usually does say that the event will happen, unfortunately, it doesn’t tell us when it will happen.

This low-volatility reading did precede all declines of 5% or more since 2009, but it did issue a false reading in 2014, indicating we should have declined 5% or more when we only declined by about 4%. So there’s no guarantee that this time around it will be correct as well, but if it is, then it implies that once this decline in share prices has concluded, it will end up being deeper than the sub-5% that we have experienced so far.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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