Low volatility — a remedy for the extremes?

A SUMMER that was predicted to create historic growth records for global markets has instead been punctuated by disturbing turbulence.

The Tokyo Stock Price Index experienced its steepest decline in nearly four decades in August as part of the most intense global market correction since the pandemic in early 2020.

Wall Street’s fear gauge, the CBOE Volatility Index, experienced a historic swing before stabilising.

The market’s sell-off may have been triggered by weak US jobs data on Aug 2, while the unexpected rise in Japanese interest rates and yen strength continued the unwinding of the Japanese yen carry trade, causing widespread unease. During this violent sell-off, large tech companies that had driven much of this year’s rally were the worst hit.

During the recent earnings season, these tech giants were already struggling, as investors’ expectations were not met. The tech-heavy Nasdaq Composite index fell by 3.4% in the last week of July, and since its all-time high on July 11, the Nasdaq declined by more than 10% by Aug 5.

Violent volatility is here to stay

Recent events serve as a strong reminder that rapid asset price swings and volatility spikes are likely to persist, especially when both macro risks such as questions about the likelihood of a recession as well as how markets were caught off guard by US economic data and geopolitical risks dominate news headlines.

Additionally, geopolitical risks, such as the potential impact of a Middle Eastern conflict, add to market uncertainty, which is heightened by the upcoming US presidential election on Nov 5.

As a result of these recent events, the need for downside protection has also increased, with a low volatility strategy capable of meeting this demand.

Stretched valuations

are a concern

In June 2024, confidence in future growth expectations reached staggering levels. To break even on five of the world’s 10 largest stocks, an investor would need to receive all of the company’s sales revenue for over a decade with the business operating for free. In some cases, the horizon of profitability extends into the 22nd century if only earnings are considered!

These companies may be able to grow into their valuations, but many operate in highly competitive, cyclical sectors that require significant research and development investments. A doubling or tripling of their revenues is no small feat for the world’s largest companies, which are near or have already reached record sales levels.

While valuations in the technology sector are most extreme, other sectors have also been affected and, as a result, there are more stocks with a higher weight in the index above the historic median (red line). This means investors pay higher prices for an increasing proportion of their portfolios as a result.

To put it in 20th century terms, they are investing during the jazz era (1920s) for a payoff at best in the rock and roll era (1950s) and in some cases in the Disco, Grunge or even early Taylor Swift era! Even this relies on two things happening until you recoup your investment:

1) That the company would return you all their earnings as dividends

2) That earnings will stay the same or increase

The first assumption is incorrect; no stock returns all their earnings and just one stock returns over half their earnings as dividends which means that the second assumption is the thing investors are pinning all their hopes on.

While it is true that you could also sell the stock instead of waiting for dividends, as many dotcom investors found out, you may not be able to get anything like the price you paid when you want to sell.

Compounding these valuation challenges is the meteoric rise of passive investment strategies. Index funds and exchange traded funds, which buy stocks based on their market capitalisation rather than their fundamental value, have become increasingly popular over the past two decades.

Is low volatility an antidote?

In contrast to market cap-weighted strategies, low volatility portfolios are constructed based on historical price stability, not stock size or growth potential.

By using this methodology, investors are steered away from overvalued, hype-driven sectors and towards more fairly valued, stable companies. In today’s growth-obsessed market, low volatility strategies tend to concentrate in sectors that are often overlooked, such as utilities, consumer staples and healthcare.

Compared to high-flying tech stocks, these sectors typically offer more consistent earnings and dividends. Additionally, the low volatility approach’s natural aversion to market manias can help prevent bubbles from forming through irrational exuberance.

Is it really different this time?

There has been a dramatic shift in the financial landscape. From dividend-focused stocks to growth-at-all-costs companies, from blue-chip stocks to high-risk tech startups, the way investors perceive and measure value continues to change.

It is crucial for investors to balance the allure of potential growth with the reality of tangible returns as they navigate this new terrain. It is not that artificial intelligence or weight loss drug innovations are not revolutionary, but as we learned in the dot com bubble, you can be right about a technological change and still be wrong about which companies will profit from it.

Even though the stock market may not return to its dividend-focused past, pendulums rarely swing in one direction.

Investors can benefit from moving some assets to a low volatility investment approach in light of these market distortions.

When investors focus on stocks with lower price fluctuations, they can potentially achieve smoother returns over time, reducing the impact of severe market downturns.

Passive strategies inadvertently increase market inefficiencies, so low volatility strategies provide a thoughtful, risk-aware alternative that may be better suited to navigate the complexities of today’s financial world.