Financial Insights

Don’t Fear Volatility, Embrace it.

Last week’s decline through Wednesday and sudden rebound on Thursday and Friday may be a mere sample of what’s to come. Investors have become sensitive to high valuations and the presence of higher economic risks.  But last week’s decline of 4% was a relatively minor drop, and the rebound left the S&P 500 down only 1.4% for the week. Growth opportunities have not disappeared, as some fear, and several higher dividend stocks provide income and still offer potential as the global economic recovery gathers steam. Investors needn’t be alarmed by the volatility, and should, instead, be prepared to take advantage of the opportunities presented.

Let’s remember that pullbacks and reversals similar to last week’s are far more common than most realize. The S&P 500 suffered drops of at least 10% at some point during the course of any given year in 23 of the past 40 years. And yet in 14 of those 23 years, the market finished the year higher than in the prior year (and mostly, a double-digit percentage higher).

Source: JP Morgan, Guide to the Markets – U.S.; Data are as of March 31, 2021. FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2020, over which time period the average annual return was 9.0%.

Investors are reckoning with elevated volatility from a myriad of sources: high valuations, greater inflation risks, and the potential for higher corporate and capital gains tax rates. These sources of risk make higher multiple stocks (and broad index funds) particularly vulnerable, and we saw the effects in last week’s pullback of FAANG stocks and other high fliers that had benefited from the pandemic. These risks do not mean investors need to withdraw from equity investments, nor does it mean investors need to give up on growth. We see appreciation drivers both near term and longer term in several areas of the market. The economic recovery is just getting started, after all.

First, reopening and recovery mean some banks, insurance, consumer, industrial and energy companies may very well outperform more classic growth companies over the next few quarters. Many of those companies also come with attractive dividend yields, which are needed by retired investors looking for income. And some of those companies can also provide protection against rising inflation and interest rates. Banks and insurance companies will see higher net interest margins as longer-term rates rise. And as economic recovery continues, loan activity will rebound and that also contributes to profit growth. Banks reported strong results for the first quarter, but loan growth was weak, and that left investors concerned. But as economic activity continues to recover—both here in the US and abroad as vaccinations increase—business and consumer borrowing should accelerate and, with that, bank profits. Reopening also points to the value of adding more international stocks (via ADRs*, for example) because the rest of the world is lagging behind the US in getting the pandemic under control. By adding some international positions, we reduce exposure to the US tax hike risk and also gain exposure to the global economic recovery, while at the same time adding an additional layer of diversification (as ACM portfolio manager David Ruff spelled out in detail in a recent commentary).

Second, structural growth drivers remain in place in several areas, and we continue to find some that are reasonably priced. Last week’s declines appear driven more by temporary forces—re-balancing towards reopening and reductions of overweight positions—than by any degradation in long-term growth potential. The fundamentals remain intact for growth, but selection has become especially important given some very high multiples. Major growth drivers include the ongoing move to digital payments globally, the switch to 5G cellular, the expansion of Cloud computing, the move to electric vehicles, the need for better cyber security, and the ongoing (and long lasting) strength in housing demand. And while the S&P 500’s valuation  appears high by historical standards—it’s trading at 22.1 times expected 12-month forward earnings—a closer look reveals the disproportionate influence of just a few particularly expensive companies. Notice that the largest companies in the S&P 500 (which therefore have among the highest weights in the Index) include some of the most expensive stocks, such as AMZN (at 53 times its expected 12-month forward EPS) and TSLA (at 122 times). In our portfolios, we have several growth stocks that trade well below the S&P multiple.

Investors also are struggling to grapple with the fixed income conundrum. On the one hand, current interest rates are especially low and the spreads on higher risk corporate bonds are pretty tight. On the other hand, fixed income provides a valued stabilizing force as part of a client’s overall portfolio. The latter can be especially comforting when economic and policy risks are elevated. Average yields may be unattractive, but by digging deep into credit risks, keeping duration relatively short, and selecting just a handful of individual bonds and preferred stocks, we are able to provide a yield well above the Barclays Intermediate U.S. Corporate Index, while keeping credit and interest rate risk to a minimum.

So don’t let higher volatility disrupt your plans. Just be prepared. And take advantage of the opportunities.

 

*ADR: An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares—often one share—of a foreign company’s stock. The ADR trades on U.S. stock markets as any domestic shares would.  ADRs offer U.S. investors a way to purchase stock in overseas companies that would not be available otherwise. Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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