Investing is often described in terms of annualized return versus risk, and risk measurements are usually derived from the standard deviation of those returns. That is where the eyes of many investors start to glaze over, and so the word “volatility” is often used as a substitute. Novice investors soon realize that for the stock market, annualized return does not equate to consistent returns year after year. There can be huge gains one year, followed by big losses the next without the longer-term annualized returns changing all that much.
It is a similar story for risk and volatility. Volatility is not constant. In fact, the variations in stock-market volatility are more extreme than stock-market returns. In other words, volatility is volatile. One of the interesting things about market volatility is that periods of very high volatility tend to cluster together. We’ve all seen the waveforms created by recorded speech. It typically has longer periods of relatively low background noise interspersed with groups of higher-amplitude sounds. This is very similar to what a long-term chart of one-day percentage gains and losses for the S&P 500 looks like.
Research has shown this to be true for nearly all financial markets. Human nature causes investors to focus on the “here and now” aspects of volatility. As such, when questioned about their tolerance for risk, an investor’s answer is often dependent on current market conditions. Given that low volatility periods are more predominate, most investors sitting down with a financial planner did so during a period of low risk.
From this, it is my belief that based on when they are asked, most investors claim a higher tolerance for risk than they actually possess. In 2007, it was easy to claim you could handle the risk of being 100% invested in the S&P 500. After all, it had been in a five-year bull market and a five-year period of low volatility. Additionally, with the benefit of 20/20 hindsight, you also knew it had fully recovered from the Tech Crash earlier in the decade and went on to new highs. Then, 2008 and a period of high volatility happened, and many investors learned that they underestimated their risk tolerance.
Income investors faced a similar situation more recently. After more than five years of market-beating performance while throwing off dividends north of 5%, many investors believed they could handle the risk of having a large portion of their portfolio in MLPs. However, like night follows day, MLP investments entered a period of high volatility last year. With most MLP investments now off 40%, 50%, or more, investors are seeing the other side of that coin.
The process of evaluating tolerance for risk requires human involvement. In my opinion, that means it will never be perfect. However, perhaps the process can be improved by the timing of those risk assessments. One suggestion would be to never conduct a risk-tolerance assessment when the market has been in an extended period of low volatility. Instead, wait for a volatility cluster or a significant decline in the investment being considered. What is your risk tolerance for MLPs today? What is your risk tolerance for small-cap stocks now that the Russell 2000 has dropped more than 20%? What about those emerging-market stocks? Now might be a good time for an honest evaluation.
Can there really be an 84-point spread between the top-ranked and bottom-ranked sectors? This week, the answer is yes. And this spread is narrower than the 94-point spread from two weeks ago. Wide spreads are not uncommon among sectors, and it is the primary characteristic that inspires sector rotation strategies. Today’s Sector Edge chart firmly demonstrates that sectors do not move in unison. Utilities, Telecom, and Consumer Staples are in intermediate-term uptrends, and the positive momentum of Utilities is quite strong. The others are trending lower. A week ago, Utilities was the only sector in the green, although Telecom, Consumer Staples, and Real Estate were poised to make the transition. Real Estate was the only one of the three that failed to do so, but it managed to maintain its fourth-place ranking. Technology and Industrials both moved higher, but only because Health Care fell. Health care was the only sector losing momentum over the past week—it dropped from fifth to eighth. Despite analysts’ claims that the raising of interest rates by the Fed will be good for Financials, the sector remains mired in a downtrend. Like a broken phonograph record that keeps skipping, Materials and Energy are at the bottom again.
All style categories posted momentum improvements for the second consecutive week, but there has been nothing smooth about the ride. Although the day-to-day market swings have affected each category, their relative-strength rankings have been surprisingly consistent. Larger capitalization stocks are viewed as being less risky by many investors, and the rankings clearly show preference for these more defensive groups. In fact, the Mega-Cap category widened its lead over Large-Cap Growth the past two weeks. All categories remain in the red, with their relative strength determined primarily by market capitalization. Mid-Cap Value and Mid-Cap Growth swapped places again this week, restoring the relationship that existed two weeks and four weeks ago. At the very bottom, Micro-Cap moved slightly ahead of Small-Cap Growth, while both continue to post deeply negative momentum scores.
Unlike the stability seen in the relative ranking order for sectors and styles over the past few weeks, the global rankings changed dramatically this week. Only one category is in the same position as a week ago, and that is Emerging Markets down in ninth place. Japan moved from third to first, as the Bank of Japan moved interest rates into negative territory, sparking a rally in stocks and weakness for the yen. Stock strength outweighed currency weakness, allowing the unhedged iShares MSCI Japan ETF (EWJ) benchmark to move higher. Currency-hedged Japan ETFs performed even better. Today, much of those gains are being erased, leaving Japan vulnerable to another drop in the rankings. The U.S. fell from first to second, while World Equity, EAFE, Canada, and the U.K. all moved higher. Canada posted the most impressive improvement, climbing from eighth to fourth as it continues to travel upward from the last place position it held six weeks ago. Eurozone plunged from second to eighth because it did not participate in last week’s global equity rally. China also bucked the positive trend and now finds itself on the bottom, relieving Latin America of that dubious honor.
“Large changes tend to be followed by large changes, of either sign,
and small changes tend to be followed by small changes.”
-B. B. Mandelbrot, “The Variation of Certain Speculative Prices,”
Journal of Business, XXXVI (1963), pp. 392–417
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