Is there excessive volatility in the stock market?
Volatility is an essential part of long-term positive investment returns. Volatility (aka risk) is what provides long-term investors higher returns than individuals who save but don’t invest. The risk-free savings rate (U.S. Government Three Month T-Bill) has produced an average annual yield of 2.90% over the last thirty years (only slightly higher than inflation of 2.50%). During the same time the Dow Jones Industrial Index (The Dow) has produced an average annual return of 10.72%. Using these two historical returns (with an initial hypothetical investment of $100,000), the risk-free saver would have $235,755 after thirty years. By contrast, The Dow investor would have amassed $2,122,180 over the same period. Risk is good. However, too much risk in a short period of time can be problematic. It can lead to fear based selling, computer programed trading, excessive short selling, lack of liquidity, loss of stock market participants, and poor asset allocation.
So where are we now? The answer from many market observers is that there is currently a lot of volatility in the market (maybe too much). The Chicago Board Options Exchange Volatility Index (The VIX) is slightly above its 10-year average (18.86 now and the average is 17.43). Triple digit daily changes are increasingly common (57 of the first 105 trading days of 2019 have posted triple digit changes). The fourth quarter of 2018 saw a peak-to-trough decline in The Dow of 18% (and then increased 11.8% in the first quarter of 2019). These figures make a reasonable case that high volatility exists. But if we pullback the perspective a different picture emerges, and with it, hidden opportunity.
D’Arcy Capital identifies the stock market as being range-bound with low volatility. This has gradually and very quietly made the stock market less expensive. The Dow first hit 24,000 on November 30, 2017. Since then it has mostly remained between 24,000 and 26,000. This is only an 8.3% spread over the last 18 months. Since The Dow first broke through 24,000 in November of 2017, there have been 377 trading days. During these 377 days The Dow traded above 26,000 only 65 days (17.2%) and traded below 24,000 on just 28 days (7.4%). Meaning, The Dow remained nestled between 24,000 and 26,000 over 75% of the time (or 284 days). During the entire 377 days the average value of The Dow index has been 25,155. Today, The Dow sits at 24,819 (only 1.3% below the 18 month average).
Although the stock market could benefit from an increase in volatility, the recent trading range (also known as market consolidation) has generated a much cheaper investment opportunity without a sharp selloff in stocks. For sidelined investors waiting for a major drop in index values before committing cash, they should shift their focus to the price-to-earnings (P/E) ratio. When The Dow first traded above 24,000 in late 2017 the price of the index was 20 times higher than the earnings generated within the index (P/E = 20). Today, the P/E ratio of The Dow is 15.8 times. This is a P/E compression of 21%. As an example; if you put a $100 into the stock market in November of 2017 you would have received earnings of $5. Today that $100 would earn you $6.33.
So what is the best approach to a consolidating market that trades in a range? For investors that are already properly invested there should be a great deal of satisfaction. You have experienced a market correction without a dramatic selloff. The risk to your strategy has lessened. It is also important to have a solid allocation to high quality, dividend paying stocks. Even if the overall price level remains in a range, investors can achieve decent returns by just collecting dividends. A portfolio of large cap value stocks can generate a steady dividend yield of 2.5% to 3.5%. Potential investors with high cash positions should now recognize the selloff they have been waiting for, has probably occurred. In the fourth quarter the stock market experienced a healthy market correction of 18%. As a result of the correction, combined with a lower P/E of less than 16 times, stocks remain cheap. And finally, if a P/E of 15.8 still seems expensive, go international. Developed international stocks have a P/E of 15.0 times (MSCI EAFE) and foreign emerging market stocks have a P/E of just 12.8 times (MSCI TR Emerging Market Index).
