Stocks Way Up, Volatility Way Down: Should We Be Alarmed?11/30/-1 Author: Dr. JoAnne Feeney, Portfolio Manager
After a brief (and small) spike in volatility around the election, the S&P 500 volatility index (VIX ©) has fallen fairly steadily and we now find ourselves back in a period of relative calm, last seen in the fall of 2014. Investors should presume it won’t last. Shortly after that 3-year lull, volatility poked its head up occasionally and with greater vigor as Greece, China, and other concerns dominated the headlines (and earnings outlooks) in mid-2015 and through 2016. Periods of calm are always interspersed with periods of volatility, or periods of volatility are interspersed with periods of calm. In truth, both occur often enough that it is impossible to discern which is normal and which is the intrusion. Today our headlines are dominated by plenty of uncertainty, which is also quite normal, yet the VIX sits at 15. Despite the fact that volatility is currently low and is likely to rise, we see several reasons for current market valuations.
As ACM’s Chief Investment Officer and founder, Dr. Charles Lieberman, wrote in a Bloomberg View column recently, stock prices may seem high, but given this period of particularly low interest rates, they still offer good value, especially when compared to the potential return on bonds. Investors remain concerned, however, about the S&P 500’s P/E multiple, now at 17.9, since it has drifted above 5-year, 10-year, and 25-year averages. Others have noted that the Shiller CAPE ratio (cyclically-adjusted P/E ratio) is close to 30, a level seen only twice before.
The CAPE ratio, however, is backward looking (it compares the S&P 500 to the prior 10-year average earnings) and has limited applicability at a time when earnings have made a shift from decline back to growth. In fact, except for a brief period near the lows of March 2009, the CAPE has suggested the stock market has been expensive for more than 20 years! This year, the companies in the S&P 500 are expected to deliver average earnings growth close to 10%, which is well above average earnings growth of 7% for the S&P since 1960. Stocks are more attractive when companies are expected to deliver faster earnings growth than in the past, so we should expect premium multiples at such a time.
Volatility remains low and that may be a signal that we are not facing imminent risk of a sharp turnaround in share prices. A recent working paper by economists at Harvard* takes a look at the risks of a market crash in the wake of stock price bubbles (defined as a 100% appreciation within two years) and they find that one significant sign of a reversal in stock prices lies in an increase in volatility. While the current rise doesn’t fall into their bubble definition, we think the insight may be broader. The VIX remains especially low, despite an apparent increase in policy risks; it seems that investors are taking those policy risks in stride. It’s possible investors recognize that government policy has had no measurable impact on economic growth in the past (we covered this back in the fall) and so any changes this time around will have only a muted effect on the overall market. Or it’s possible that investors recognize that some policy changes (e.g., lower corporate taxes and fewer regulations) will help earnings, while others will hurt (border tax), so that the downside risks are limited. Or it could be that many expect the usual Washington gridlock (or party compromises) to prevent policy from changing in too radical a way.
Recent data continues to support our view that the US economy remains robust – jobless claims are way down (weekly jobless claims hit a 40-year low and that’s not even adjusting for the growth in population) and services activity picked up steam last month (and has been in expansion territory for the last 86 months). Our chief concerns lie in the risks of faster interest rate increases than the market expects and the disruption that would be caused by costly tariffs on imported inputs and consumer products, although we don’t think this is very likely as it does not have strong GOP support. There is nothing to be done about the former since pressures are building for rate increases, but we received some good news regarding the latter. The administration finally appointed a chairman to the Council of Economic Advisors, Kevin Hassett, and the selection gives us reason to believe more free-trade oriented policies will survive the current drift towards protectionism.
While the S&P 500 valuation has risen above historical levels, the return of capital investment activity among firms, the possibility of lower taxes and less onerous regulations, the recent positive economic data, and the possibility that the US may yet hold to a relatively free trade stance underpins the above-average outlook for earnings growth this year and next, and this provides a foundation for valuations above the historical average. But if the policy expectations embedded in share prices fail to materialize, or end up more onerous than constructive, expect volatility to return and with it a resetting of stock valuations. Because of that threat, we continue to target investments in firms trading below the current market P/E.
* “Bubbles for Fama,” by Robin Greenwood, Andrei Shleifer, and Yang You, Harvard University Working Paper, revised, February 2017.