Investors have been forewarned for some time that we are in the late stages of a bull cycle when risks are heightened for those with exposure to the share market. While the size of any pull back is unknown, one thing we do expect is increased share price volatility.
Keeping things in perspective, 2017 saw the market experience its lowest volatility this century. Calm heads prevailed, and investors grew more brazen in their risk taking as confidence grew that the market was a safe place to play. However, in 2018 the bounce back in volatility was rapid as investors become increasingly spooked by events here and overseas. Looking at the VIX Index, commonly referred to as the “Fear Index”, we can see that the expected volatility of the U.S. stock market picked up in 2018, relative to the prior year.
Source: Stock Doctor / Bloomberg
Old stock dogs will see this market as simply behaving normally. Looking at the chart of the VIX index, investors should be happy that we are yet to experience the extreme volatility of periods of the last 10 years, particularly during the midst of the GFC. Though the median average of the VIX over the past 10 years has been 16.72, we currently sit at 19.89. It suggests the market is more nervous than usual.
So how do we manage such periods?
Many investors have been left holding the can trying to pick tops and bottoms in the market, only to get their timing completely wrong with a savage shift costing them in terms of long-term returns. So rather than worry about timing cash into and out of the market, investors should first ask themselves whether they have the correct allocation of their overall portfolio exposed to the share market and the portfolio is aligned with their defined investment strategy.
Once this has been done the question becomes what style of investing is best to ride out the volatility and come out the other end with success. A ‘go to’ position for many commentators is to suggest that stocks to avoid are the ones that have run up the hardest and are most at risk of an imminent correction. These are often high quality / high growth businesses that are seen to be trading at a high PE ratios and therefore higher risk of a collapse. But, as the recent savage fall in The Reject Shop Limited (TRS) reminded investors last week, just because you are ‘cheap’, doesn’t mean you are immune to a savage sell off during the late stages of a bull market.
Statistics suggest that your focus should be on investing in businesses that exhibit quality factors, as they outperform in volatile times. This is because during times of turbulence when markets fall, they lose less and on the other side and recover faster. The chart below shows the performance of quality factor investing against other factors. When the line goes up, it means quality investing is outperforming the broader index. When overlaid with the VIX index, and highlighted the periods where extreme volatility occurred, it is clear that during periods where fear was greatest, stocks that exhibited quality factors outperformed their peers and provided the best haven, outside of cash, to whether the storm.
Source: Bloomberg / Lincoln Indicators
In September 2018, the Global Quantitative Research team at Macquarie Group produced a report entitled “Gravity Free Investing”. They wanted to answer the question, “How should investors position on the back of increasing macro / policy uncertainty? “
Whilst highly technical in its application, the outcome was simple; periods of rising uncertainty favours Quality / Low Volatility factors. In their words, despite their expensive valuations these stocks will continue to attract flows as investors fear ‘unknown unknowns’. Through statistical analysis back to 1990 they found that Quality portfolios are negatively correlated to periods of heightened economic uncertainty, versus Value which is positively correlated. This lead to the conclusion that quality stocks do better than value stocks when economic uncertainty is high.
Our long-held view at Lincoln Indicators is the best way to invest in all markets, irrespective of where the investment cycle currently sits, is simply by investing in quality businesses as a priority and avoiding the bad ones. The quality factors we seek in the companies flagged as Star Stocks are financially healthy, generate profit efficiently with good cash conversion, and have good growth prospects moving forward.
As highlighted in this article, history tells us that being in these quality stocks is the best way to ride through volatile periods in the market.