by High Volatility Leads To New Opportunities
Since the beginning of 2018, we have seen equity markets be volatile, and within August, the Volatility S&P 500 index (VIX) has seen higher highs and higher lows. VIX is often referred to as the fear index or the fear gauge because higher volatility equals higher uncertainty in the markets. In a 2011 report, Crestmont Research found that higher volatility corresponds to a higher probability of a declining market, while lower volatility corresponds to a higher probability of a rising market. With this surge in volatility, some equities have likely seen high price increases while others have declined, and this creates new opportunities for us. The question then becomes whether or not we can use this increase in volatility to capture new opportunities, with still recognizing that there is a higher probability of declining markets.
We can use this information to implement one of the most well-known trading strategies; Mean reversion (sometimes referred to as the law of averages). In short, this strategy suggests that prices will revert to a long-run average. One of the measures that we will use to further this research is P/E ratios. As shown in the picture on the right, P/E10 for the S&P is at its highest level since the Dotcom bubble. Notably, the current level is the 3rd highest with only the Dotcom bubble and the great depression being higher. The P/E10 has a historical average of 16.9, and at current levels, US equities are overvalued.
With current valuation levels, Laker Asset Management (LAM) should consider investing in less cyclical stocks. Sectors such as consumer staples that are less affected by economic downturn typically have lower valuations in economic upturns. Investments in equities with these characteristics will also bring LAM’s overall portfolio deviation down.
Another area of opportunity is the European equities. Since 2009 a gap has formed between international and US price valuations, which deviates from the high level of correlations between the two. There are different reasons why valuations are higher in the US, but the fact remains some European equities have very low valuations as compared to American equities. Click here for an interactive article about worldwide valuations.
What now?
In the next few weeks, our team will dive deeper into this theme. Our objective is to find undervalued companies that might fit into our portfolio matrix. The companies that our team researches will then be added to our watchlist, and hopefully lead to sound investments.