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Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: Minutes from the latest Fed minutes were released Wednesday and it showed officials were generally in agreement on the approach to unwind the central bank’s $4.5 trillion balance sheet. What were your thoughts on the statement and the market’s initial response?

Stovall: My feeling is that the Fed is really just trying to take a gradual approach to unwinding this massive balance sheet. They are letting us know early in advance as to when they are going to start winding it down and how they’re going to actually do it. Therefore, they’re basically giving us the play-by-play so that nobody is taken by surprise. I think that will end up being a good thing, and will cause investors not to have a negative response.

EQ: The balance sheet roll-off has been compared to the Fed’s tapering of quantitative easing back in 2013. The “taper tantrums” during that period added significant volatility to the market. Could we see a repeat of that, or do you think the Fed has learned from that experience?

Stovall: I think the Fed has learned from that experience because they realized what happened when then-Fed Chair Ben Bernanke implied tapering, and then incoming Fed Chair Janet Yellen pretty much agreed early in her term, and the markets responded quite negatively both times. So, I think that they have learned their lesson, and are now letting us know what they really plan on doing, which is increasing the amount by which they phase out the debt very gradually, and then not go beyond a certain threshold. They want to avoid flooding the market with bonds that need to be purchased by somebody other than the Fed. So, by taking a gradual and very transparent approach, it will help to avoid a repeat of the taper tantrum response.

EQ: In this week’s Sector Watch report, you discussed what volatility-adverse investors can do if they prefer a calmer ride through the market. That’s especially relevant now with the Fed unwinding its balance sheet and speculation of President Trump possibly being impeached. How can investors leverage low-volatility portfolios to enhance their long-term returns?

Stovall: Financial advisors have been telling clients for years that the only way to outpace inflation is to own equities. Yet, a lot of times, the volatility in those equities can dissuade somebody from having too great of an exposure to the overall stock market. So, one way to be able to convince yourself that you can actually own equities over the long haul is by focusing on those stocks that have less wiggle, if you will, or less volatility than the overall market.

There are smart betas out there that are tied to S&P and MSCI Indices, such as the S&P 500 Low Volatility Index, as well as the MSCI EAFE Minimum Volatility Index. So, investors could gravitate toward these vehicles to still be invested in stocks, yet feel like they’re riding the Merry-Go-Round rather than the rollercoaster.

EQ: Looking at the long-term outperformance of the low volatility portfolio versus that of a traditional 60/40 portfolio really highlights the toll volatility can have on investors. While volatility is great for short-term active traders, why is it so harmful for long-term passive investors?

Stovall: The interest thing is, if you lose less on the way down, you have less to recover when the market finally gets back to break-even. There tends to be a pretty positive correlation in that a rising tide lifts all boats. So, in a bull market, high- and low-volatility stocks will go up, and in a bear market, high- and low-volatility stocks will go down. It’s just a matter of the magnitude of the move based on the direction.

Going back over the past 20 years, a diversified, global portfolio posted a compound rate of growth of 7.3%, a monthly standard deviation of 10.3, and rose in price almost eight out of every 10 years. That portfolio is constructed in that the 60% equities component is broken down into 30% in the S&P 500, 10% in the S&P MidCap 400, 5% in the S&P SmallCap 600, 10% Developed Markets, and 5% in Emerging Markets.

Yet, when substituting these broader benchmarks with their low-volatility counterparts, by maintaining the same exposure, an investor would’ve ended up with 8.1% CAGR with a more-than 30% decline in overall volatility, and a frequency of advance that is closer to 90%. I think one reason is because we had two mega-meltdowns (bear markets of 40% declines or more) right after the Tech Bubble burst in 2000-02 as well as the Financial Crisis of 2007-09.

So, if investors think that we’re headed for another “big one” then they might want to be emphasizing the low-volatility components of major benchmarks rather than the benchmarks themselves.

EQ: Could this also serve as a convincing counterpoint to those investors with longer-term time horizons that feel they’re better off with high-risk/high-reward approaches?

Stovall: Well, some people do worry that these low-volatility investments own a lot of stocks that are high in dividends because usually high-dividend paying stocks have lower overall volatility. While that is true, this portfolio gets re-evaluated every quarter, and in the case of the S&P 500 Low Volatility Index, it’s the 100 stocks with the lowest trailing 12-month standard deviation.

So, should there be a pickup in volatility if the bull-bear debate starts to intensify surrounding a particular stock or a particular industry, they’re going to get jettisoned from the portfolio. So that’s one reason why the low-volatility index declined 21% in 2008, versus the 37% for the S&P 500 itself. So, this 100% low-volatility portfolio actually did better than the average balanced fund in 2008.