Low volatility strategies overbought
One of the greatest reverse indicators is ‘what is the hot retail product’. As we know, retail investors in particular react to recency bias. They buy what has worked recently, not what should work in the future.
In late 2014/15, $40bn went into dollar-hedged international exchange-traded funds after the dollar had dramatically appreciated against foreign currencies.
The year before that, the hot product was Master Limited Partnerships (MLPs), which ultimately were brought down with a collapse in oil prices nobody predicted.
Most popular this year are low-volatility, high-quality, dividend-yielding strategies, which have seen more than $10bn of inflows year to date.
Stocks with good dividend yields and low beta may be hot right now, but at what valuations? The two most expensive sectors of the S&P 500 today are consumer staples and utilities, common exposures within low-volatility strategies. Our research suggests the 200 least volatile stocks in the Russell 1,000 are trading in the 95th percentile of historical relative valuations.
But rarely would valuation alone bring down a group of stocks, and how can this be bullish for the market? Whenever a product gets crowded, one has to pause to question what could cause underperformance, as did lower oil for MLPs and a lower dollar for hedged ETFs.
We have no idea when this low volatility bubble will burst, but utilities were up by 23.5% in the first half of the year while growth sectors such as technology and healthcare were down for the year, meaning reversion to the mean may not be far away.
If history is any precedent, the bubble may not burst because low-volatility stocks go down but rather that the market breaks out to the upside, causing reversion to the mean, simply because the low-volatility sectors underperform.
More importantly, the past three times low-volatility stocks became this expensive relative to the market, in November 1990, October 2002 and March 2009, the S&P 500 rallied significantly during the next 12 months, once again wrong-footing investors.
High-yield spreads contracting
The direction of high-yield spreads has been a decent predictor of the near-term course for the equity markets and the economy over time. Last May, high-yield spreads bottomed prior to the market running out of steam in early summer.
Spreads widened until February as the market sold off and recession fears grew. Today, spreads have contracted to about half of that widening (see Chart 2). Tighter spreads are a bullish sign for the economy.
Bullish breadth
Since the lows in February, the market breadth has been improving steadily, which is healthy. Breadth is a measure of the number of stocks that are participating in the rally, and a market rally on wide breadth is a bullish sign.
Since the Brexit sell-off, the breadth thrust has been extremely powerful. In fact, during the past 25 years, the S&P 500 has always been higher six to 12 months forward after this level of market participation.
In conclusion, the bottom line is that we now have a high degree of confidence that value stocks will outperform going forward on a relative basis.
The cautious view we have espoused all year, of ‘don’t expect much from the market overall in 2016’ seems emotionally correct during these summer months, but the green shoots we are now witnessing leads us to conclude the overly bearish consensus positioning could be wrong.
