Value is expensive. I am not sure that’s possible, etymologically speaking, although as it has happened it must be.
Investors are getting used to believing six impossible things before breakfast, as Lewis Carroll’s White Queen could. In a world of negative interest rates, this is the norm. Overnight I read another piece about Canada’s multiple investment bubbles and I am sure that one day they will all burst.
Timing, though, is everything. As a young man I worked in Malaysia during the frenzied stock market run of the 1990s. Each year more investors would come to visit (and shop), count the cranes building skyscrapers and return home bearish. One guy turned the taxi around within ten minutes of leaving the airport and took the next flight home. Eventually one of the visiting investors got their timing right. It would be nice to think it was the airport guy, but I can’t be sure.
Low value equates to low volatility. As this survey shows, low volatility is also low beta and financial strength. Yet over the long term, neither extremely low nor exceptionally high volatility delivers the best performance. That comes from stocks with middling risk.
This is logical. One test of any mathematical model is that it delivers intuitive results. Volatility is risk and if the lowest risk stocks always delivered the highest returns, then their price would be bid up to unsustainable levels. Equally, while risk and return are related, if constantly buying the riskiest stocks delivered the best performance, the word conservative would have fallen out of use.
How do we track this in OTAS? Median implied volatility for the largest stocks in the US is 24, which means that in three months’ time the average share is predicted to be up or down by 12%. The stocks with below average implied volatility have an average forward PE around 18x. This is a slight premium to the market.
Over time, the stocks that currently have below average risk trade at the same PE as the market. Not all of today’s low vol stocks will always have been less risky, but a lot of them will have been. The chart shows that when the PE premium in low risk stocks reaches 7%, the next move for the market is down.
There are arguments as to why low risk stocks might have the highest potential growth. Strong balance sheets leave scope for leverage and with all the free money sloshing around, buybacks can be used to raise EPS. But Q2 buybacks were the lowest for two years.
Alternatively, all the strongest stocks have the funds to invest in future growth, while the risky stocks have none and hence their earnings will fall. Also, low risk means low return, which equates to high current PE. And that is the point; when the PE of low risk stocks reaches a certain relative level, the low return element of the deal kicks in and stock prices fall.
This typically occurs when the market as a whole falls. When indices retreat from highs, the low risk stocks fall the furthest. Then a few more hedge funds close claiming the market to be irrational.
Canada’s still booming, there is tremendous demand for bonds that you pay to own and the least risky stocks have the highest expected growth. It’s not impossible that this continues, but history suggests that it is unlikely.