Valuations and Aging Bull Market Point to Volatility Management

This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.

US stocks have delivered solid double-digit returns in five of the last six years1 — a run that ranks solidly within the five longest and strongest bull markets for the S&P 500 Index since the Great Depression. As investors survey today’s investment landscape, they’re asking a very important question — is there still opportunity in US equity?

Valuations and volatility

Although underlying earnings growth was solid for US companies in the fourth quarter of 2014, stock valuations have been stretching, indicating that stocks may become overpriced. We see four key catalysts that could drive continued expansion in price-to-earnings (P/E) ratios:

  1. A persistently strong US dollar that may create a headwind for US earnings growth.
  2. A backdrop of low interest rates that may make equities look attractive for return-seeking investors.
  3. Solid fourth-quarter earnings that fueled investment inflows from those who may feel like they’re missing out on the benefits of the maturing economic expansion.
  4. Declining oil prices that support the outlook for economic growth outside of the energy sector.

To understand the potential investor implications of expanding valuation multiples, we studied the relationship between P/E expansion and 30-day historical volatility. Not surprisingly, from March 1990 through December 2014, periods in which multiples were expanding have often been characterized by rising volatility. Intuitively this makes sense in our view, as investor jitters are likely to increase as the relationship between price and earnings expands.

Today, we’re seeing a rise in volatility — the confluence of a strong dollar, falling oil prices, the Chinese real estate dislocation, geopolitics, and lackluster growth in Europe caused three-month historical volatility on the S&P 500 Index to trend higher from its level of 6.2% at the end of the second quarter 2014 to 13.4% by the end of the fourth quarter 2014.2 In addition, the widely followed CBOE VIX Index remained below 18 for most of 2014, but was 19 or higher during 16 of the 26 trading days through Feb. 9, 2015.3 The rise in the VIX may indicate that volatility may be normalizing from its low levels in 2014 and hints that a higher level of volatility may become a feature of the 2015 equity market, in my view.

Our equity outlook: Be prepared for higher volatility

Given how far US equity markets have come since the March 2009 bottom, we believe it’s highly likely that we’re much closer to the end of this bull market than the beginning. While our outlook for US stocks in 2015 remains constructive, we believe investors should talk to their advisors about the risks associated with the aging bull market, and tools that can help manage portfolio risk. We believe smart beta strategies that focus on low-volatility stocks may help with that goal.

Investors, learn more about smart beta exchange-traded fund strategies.

Advisors, log in to download the PowerShares Connection Report for February for a more in-depth look at the issues discussed in this blog.

1 The S&P 500 Index returned more than 10% in 2014, 2013, 2012, 2010 and 2009.