Investors have been playing defense in recent months, piling into bonds despite low yields, sleeping well at night with gold purchases, staying with the perceived safety of U.S. stocks, avoiding risky small cap companies, and buying traditional low-risk sectors including Utilities, Consumer Staples, and REITS. Perhaps today’s preference for safety is best exemplified by the relative total return performance of the S&P 500 Low Volatility Index, which comprises the 100 least volatile stocks in the S&P 500. In the last six months, this index has trounced the S&P 500 by about 660 basis points! This represents one of the best six-month periods (the six-month excess return is better than 88% of the time) for low volatility investing from 1989 forward!
Until the Great Recession of 2008, periods of significant outperformance by the S&P Low Volatility Index signaled pending economic weakness and greater difficulty in the overall stock market. However, during this recovery, like many traditional indicators in this unconventional expansion, the performance of the Low Volatility Index has experienced a complete “Signal Switch!”
Low Vol Investing Has Changed Its Stripes
Customarily, low volatility investments were used primarily as a defensive hiding place during an expansion’s inevitable periods of economic weakness. However, post-2008, they have increasingly become one of the quintessential “safe haven” assets during a fearful storm. Their periodic popularity no longer reflects a simple desire to lessen cyclicality. Rather, like gold, Treasury bonds or cash, low vol investing provides a good night’s sleep and a calming protection from those worst-case nightmares. That is, the performance of the S&P Low Volatility Index has become a sentiment measure—or fear indicator.
Perhaps the change in low vol investing is best exemplified by its increasingly close relationship to the bond market. From 1990 to 2007 (Chart 1), the correlation between the daily Low Volatility relative total return index and the 10-year Treasury bond yield was only -0.27. While low vol investments tended to do well when bond yields declined, the relationship was loose at best. However, since 2008, the correlation has surged to -0.73, aligning the return character of low vol investing remarkably close to that of the bond market (Chart 2). In other words, the S&P Low Volatility Index has gone from a traditional bond-sensitive investment prior to 2008, to a “bond-surrogate” during the current recovery!
The Traditional Low Vol Signal?
As recession fears have escalated in recent months, many investors have turned more bearish on the overall stock market and increasingly favor defensive investments including low volatility stocks. Traditionally, turning cautious after a period of solid outperformance by the S&P 500 Low Volatility Index proved profitable.
As illustrated in Chart 3, between January 1990 and December 2007, whenever the past six-month relative total return performance of the Low Volatility Index was among the best quintile returns (as it is at present), allocating more toward low volatility (and defensive stocks in general) was highly successful. Top-quintile, past six-month relative performance led to an average six-month “forward” outperformance of +6.58%! Moreover, the chance of underperforming in the coming six months was less than 30%. By comparison, when the past six-month relative total return performance of low vol investing was among the lowest-four quintiles (either a smaller outperformance or underperformance), the average six-month forward relative total return was negative (i.e., -1.05%) and low vol investing underperformed the S&P 500 in the coming six months almost two-thirds of the time! Essentially, the S&P Low Volatility Index has often maintained strong positive return momentum subsequent to a solid six-month run.
As shown in Chart 4, not only was strong outperformance by low volatility stocks a good omen for continued low vol outperformance in the coming six months prior to 2008, it also proved prescient in correctly signaling defensiveness toward the stock market in general. After a six-month period of top quintile outperformance by the S&P Low Volatility Index, the average six-month forward total return for the S&P 500 Index was -0.75%, with a 51% frequency of negative six-month forward total returns!
Given the historical efficacy of the S&P 500 Low Volatility Index in forecasting defensive stock leadership while the stock market as a whole struggles, it is understandable why its recent significant outperformance has frightened bulls and caused many investors to increase defensive allocations of late. However, like many conventional gauges since 2008, the Low Vol Signal has changed its stripes.
The NEW Low Vol Signal?
Many things changed following the Great Recession of 2008. The persistently-slower pace of economic growth, monetary and fiscal policies having less impact on economic activities, unprecedented central-bank balance sheets, and a plethora of negative-yielding bonds about the globe; hence, several old signals have lost their predictive power (e.g., the 2% real GDP-growth stall speed, wage inflation at full employment, the bond market term premium, capacity utilization rates perpetually below 80%, and buying value stocks once they are cheap).
Another casualty of the post-2007 experience is the S&P 500 Low Volatility performance signal. Charts 5 & 6 show that the Low Vol Signal “completely reversed” from 2008 forward! In the current recovery, when the last six months’ relative total return of the S&P 500 Low Volatility Index has been in the top quintile, the future six-month relative total return for low vol stocks has averaged a loss of -0.84%; and, it underperforms the stock market in the coming six months more than 60% of the time! Since 2008, in stark contrast to earlier periods (Chart 5), it’s been best to allocate toward defensive/low vol stocks in the aftermath of a six-month period of mundane, or poor, low vol stock performance (i.e., in the lower-four performance quintiles).
A similar shift in the Low Vol Signal for the stock market is illustrated in Chart 6. In contrast to years prior to 2008, in the last ten years the stock market has performed best in the six months following a six-month period of top-quintile, low volatility relative total return. When low volatility performance has been strong, the S&P 500 has provided an +8.63% average six-month forward total return and has only posted a negative six-month forward return 13.1% of the time. This compares with negative forward returns more than 25% of the time, and an average forward total return of only +4.47% the rest of the time.
Low Volatility Leadership Now Implies Better S&P 500 Returns!
Between 1990 and 2007, periods of superior performance by the S&P Low Volatility Index were a sure sign it was an occasion to load up on defensive stocks because the overall stock market was headed for trouble. In the last six months, the excess total return from the S&P 500 Low Volatility Index has been better than nearly 88% of the six-month periods 1990-to-date. Consequently, based on the historical signal from low vol stocks, many investors have recently adopted a more cautious approach toward the stock market and have boosted defensive exposure. The problem is, the recommendation from the low volatility stock signal has switched. Outperformance by low volatility during the last six months is now “good” for future six-month returns in the general stock market, but “bad” for future returns from low volatility investing, itself.
Why has the Low Volatility Signal completely reversed in recent years? Prior to 2007, low volatility investing was considered a defensive hedge against anticipated weakness in economic conditions. Therefore, outperformance by the Low Vol Index typically foretold a coming economic slowdown, challenging the stock market and making the character of low volatility investments even more attractive.
Since 2008, however, low volatility investing has become a bond market surrogate, an investor sentiment indicator and/or a fear gauge. As such, periods of healthy outperformance by the S&P Low Volatility Index no longer suggest a pending cyclical economic challenge, but rather, exemplify extreme investor pessimism or fear. While good low vol performance used to be a leading indicator of economic and general stock market weakness, in more recent years it has become a “contrarian indicator” like other measures of investor sentiment.
The S&P Low Volatility Index has done tremendously well in the last six months. Most seem to believe this is signaling weaker economic growth and continued outperformance by defensive/low volatility stocks, as it did between 1990 and 2008. However, during the last 11 years, the Low Vol Signal has completely switched, and its recent outperformance is likely signaling excessive investor pessimism/fear, which argues for a much more favorable environment for stocks during the next six months, while low vol stocks underperform.