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Beware the VIX, prepare for a more volatile bull market

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The return of volatility does not mean that it is time to sell. On the contrary, global growth is still good, earnings growth is strong, and equity market valuations remain appealing relative to cash and fixed income.

ALTHOUGH the VIX (CBOE Volatility Index, which measures expected volatility in the US stock market) has declined to a near-four-month low, 2018 overall has seen the return of volatility.

The biggest peak-to-trough fall in global stocks last year was less than 3 per cent. Already this year, there has been a 9 per cent peak-to-trough decline.

Choppier markets reflect concerns that the economic upswing will soon come to an end amid higher inflation, rising US interest rates, the end of quantitative easing, and a trade dispute between the US and China.

Yet investors face a potential conundrum. The return of volatility does not mean that it is time to sell. On the contrary, global growth is still good, earnings growth is strong, and equity market valuations remain appealing relative to cash and fixed income.

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Global equities are currently valued at 16.7 times companies' earnings, compared with a 30-year average of 17.8. Historically, only multiples above 23 have been consistent with negative average subsequent returns.

In short, we think that being invested in equities is quite likely to work in the short run, and very likely to in the long run.

Over the past 90 years, investors with a 10-year time horizon have earned a positive return from the S&P 500 on 95 per cent of occasions. Timing an exit from stocks before the onset of a recession can also be tricky.

While the average rise in the final year of the bull market is 22 per cent, the average recession is accompanied by an equity drawdown of around 2030 per cent, based on data since 1928.

Investors need to both be invested and manage risks. Those in properly diversified portfolios are well prepared for the return of volatility. But many others are relying too heavily on passive approaches in traditional markets; not managing equity downside risks appropriately; holding concentrated positions; focusing too heavily on generating yield while neglecting risks; and lacking a suitably long-term approach.

To prepare for this new environment, we recommend five main approaches:

  • Adding alternative sources of return beyond classic equity and bond indexes. For instance, an equally weighted US equity portfolio oriented towards five of the most frequently cited performance factors, such as size and quality of company, would have outperformed the S&P 500 by 1.9 percentage points a year since 1998.
  • Lowering vulnerability to equity drawdowns. For those investors who can use options, one method of downside protection is to buy put options. When options are not appropriate, diversification, systematic rebalancing and setting aside funds for short-term spending can provide equally effective protection.
  • Diversifying globally can help reduce exposure to specific risks. Those averse to owning foreign equities can also seek out homegrown companies with high international exposure.
  • Reconsidering sources of income away from risky credit. The yield on riskier corporate bonds is no longer sufficient to compensate for a rise in defaults. Investors looking to earn yield without taking on excessive risks can consider dividend-paying stocks and longer-duration government bonds (which can also offset market turbulence).
  • Looking beyond the economic cycle with allocations to private markets, sustainable investments, or long-term themes (for example, certain areas of technology or emerging markets) can help boost returns or reduce the temptation to sell at the wrong time and retreat to cash.

In sum, investors should prepare their portfolios for the return of volatility to levels we have not seen in years. But with economic and earnings growth still strong, we do not believe that selling out of riskier assets in favour of cash is the right response. Instead, by seeking alternative sources of return, adding downside protection, and investing with a longer-term mindset, investors can reduce drawdown potential and position for long-term portfolio growth.

  • The writer is is chief investment officer at UBS Global Wealth Management.