A Tale of Volatility and Valuations
First, volatility is starting to rise, but from very low levels. Last week may have left investors feeling as if markets have become much more turbulent, but it’s important to put things in perspective. Volatility is still low by historic standards. During Thursday’s sell-off, the VIX Index, a key measure of equity market volatility, peaked at around 16, still 20% below the long-term average. But an impending rate hike from the Federal Reserve and slightly less benign credit conditions are having the predictable impact of nudging volatility higher. As investors begin to prepare for a first rate hike, volatility should continue to normalize.
Second, not all market segments are the same. Equities were generally off last week, although they recovered somewhat on Friday. Indeed, stocks have been struggling since the S&P 500 first crossed the 2,000 threshold in late August, but individual market segments are behaving differently. For example, while U.S. large caps are down barely 2% from their peak, small-cap stocks have never managed to eclipse their February top and are now down roughly 8% from their summer highs.
This leads to the third lesson: Focus on relative value. In many cases, the parts of the market that have been performing better of late are some of the relative bargains.
One of the reasons small-cap names have been struggling is that their valuations are considerably more stretched than those of their large-cap cousins. Based on current earnings, U.S. small-cap stocks trade at around a 60% premium to large caps. That large premium — the result of multi-year momentum-driven gains — appears to be hurting the sector.
On the other hand, one of the interesting aspects of last week’s sell-off was that two of Asia’s largest markets — China and Japan — managed to buck the trend and finish higher. Chinese equities benefited from a better-than-expected manufacturing release while Japanese stocks seem to be responding to share buybacks, which have now reached a six-year high. All that helped, but stocks in Japan and China are also benefiting from modest valuations, at least compared to equity markets in the U.S. and Europe.