Here's the Deeply Depressing News About This Market
When the stock market gets choppy, as it is now—the Dow Jones industrial average plunged by triple digits again on Wednesday — equity investors tend to set sail for calmer waters.
Historically, that's led them to a few sheltered corners of the market.
First, there are high-yielding stocks, where payouts to shareholders serve as a cushion when stock prices crater. Dividend-paying stocks don't prevent losses altogether—this is the stock market after all—but during the 2008 financial crisis, for instance, when the S&P 500 lost 37% of its value, the SPDR S&P 500 Dividend ETF fell just 23%.
Investors also look for safety in so-called low-volatility stocks. These are shares of "steady Eddie" companies, often found in stable but slow-growing and boring businesses, that usually gain less than the broad market during upturns but lose less in downturns. Among the biggest holdings of the PowerShares S&P 500 Low Volatility ETF , for example, are Coca-Cola and Warren Buffett's insurance and holding company Berkshire Hathaway .
History says that both dividend payers and low-volatility stocks not only provide ballast in turbulent times but actually outperform the broad market over the long run.
Normally, tilting your portfolio toward either of these types of stocks would make sense if you're worried that the recent jump in volatility -- as seen below in the CBOE VIX "fear" index -- is a sign of worse things to come.
Trouble is, nervous investors jumped the gun and bid up shares of dividend payers and "low-vol" investments before volatility actually manifested in the economy. Indeed, from 2009 to the start of this year, dividend investing proved to be one of the easiest ways to beat the market:
In other words, these two conservative and time-tested ways to stay in stocks are now expensive on a relative basis. And recent history tells us that buying an overvalued stock is fraught with risk.
Take dividend payers. They typically sport lower price/earnings (P/E) ratios than the broad market because high-yielders tend not to grow that fast. (That's why they return dividends to shareholders in the first place.) But these days the average P/E for stocks in the SPDR S&P 500 Dividend ETF is 18.3, based on projected future corporate earnings. By comparison, the average stock in the broad market trades at a P/E of 17.
Similarly, the average holding in the PowerShares S&P 500 Low Volatility ETF trades at a higher-than-average P/E ratio of 18.
The problem with these frothy prices is that they detract from the stability that these types of stocks normally provide. Feifei Li, head of research at Research Affiliates (a major proponent of low-volatility investing), published some thoughts last year about rising prices and valuations in the low vol space. Li noted:
Empirical evidence demonstrates that low volatility strategies offer higher-than-market returns and considerably lower risks... Not surprisingly, these desirable performance characteristics have attracted many players to the market ... The fast pace of growth raises the question: Does the rapid flow into this space erode the strategy’s effectiveness in delivering attractive risk-adjusted returns? This is a legitimate concern.
Does this mean you should avoid low-vol stocks and dividend payers altogether? No, but it will take more work to find the handful of examples of these types of stocks that are undervalued and attractively priced.
Hey, no one said avoiding a downturn — while remaining in the stock market — would be easy.