Alternatives For An Investor Averse To Volatility

Apr.30.14 | About: SPDR S&P (SPY)


Investors tend to fear the summer months of the market, hence the "Sell in May and go away" concept.

Volatility has been absent from the market for almost two years now.

Those who dislike whipsawing or want "easy money" may want to switch to alternatives.

A sideways YTD S&P500 (NYSEARCA:SPY) and Russell 2000 (NYSEARCA:IWM)? We haven't seen that in a long time.

Statistically, between November and April, there is a bias to the long side of the market where investors feel comfortable putting a little more risk on the table. Conversely, when May shows up market participants in general like to either remove exposure or switch to other investments that usually preserve capital and generate yield. I have seen multiple instances where fund managers are interviewed and they discuss basic seasonality trading and trends. In principle, management provides short-term trading teams with more capital, while shrinking net long. They not only like to take advantage of enhanced volatility but also switch into "safer" areas. One common example is transitioning allocation from "growth" into "value". As a side note, people should not distinguish these two features, growth is a function of value otherwise the business would be a cash cow or otherwise declining.

Current Market

Providing some application, large caps and mega caps, have been bid up significantly in the last 3 months. People view businesses that have been around for a long time with strong fundamentals are good ideas. Some money managers look at it from a technical point of view, using beta for instance, assuming that if the market tanks or economic disparity arises these companies will likely be the least influenced. That is true to a point however people must not detach the bigger picture from inherent value, like top-down versus bottom-up. In fact, I think right now "safe" businesses like Johnson & Johnson (NYSE:JNJ), Walmart (NYSE:WMT), McDonald's (NYSE:MCD), and Exxon Mobile (NYSE:XOM) offer little upside since they have been bid continuously higher and therefore trade at a premium. I am not saying avoid these picks but I am simply not a buyer here.

So what are the best options? That's a very good question when you have a seemingly overheated market with apparent indecisive price action.

A) Preferred stock. Plain and simple. If the business is cash rich and has good prospects investors should be able to sleep at night. Yes, most PS is non-cumulative but how bad would that look if a corporation continuously did not pay their shareholders? One quarter missed without reason and the price can go down the tubes; it's an unlikely scenario and very rarely happens. Not to mention if a dividend is paid to the common shareholders, that will have to be suspended before preferred interest is threatened. This is probably the number one go-to plan for fixed income while attempting to avoid disaster.

B) Low beta positions. One thing that works overtime is looking for equity with yield that tends to drop less than benchmarks (side note: beta is related to price, not value, and therefore not risk). A few good examples of this are telecom, utilities, and REITs - it's also unlikely that one of these business models will evaporate overnight like other ones could (REITs may be an exception based on circumstance). During the financial crisis, the larger boring companies within these industries saw not only a much lighter decline but shareholders were compensated for holding their positions via dividends typically hovering around 4-5%.

C) Trading in and out. I mentioned in one of my previous articles that people can time the market if they have a defined strategy, are flexible, and ultimately disciplined. To put it bluntly, this is not a path for the emotional or risk intolerant. Every trader, professional or not, can experience phases of inadequate returns or even losses. You have to be confident in yourself but don't be arrogant. While most people refer to the summer months as boring, it can be completely the opposite if you can move into the market appropriately; there is plenty of opportunity!

What May Be Ahead

This is a snapshot of what many investor savvy individuals monitor on a monthly to yearly basis. It gives a relative idea of where the market is in terms of valuation. (click to enlarge)Click to enlarge

This is the fourth highest seen to date, still riding under the Roaring 20s, the dot com boom, and housing bubble. Not very comforting for a long term investor so it certainly heeds caution.

For those who do not know, in my last article I just skimmed over the volatility index (VIXCBOE) briefly, and it's actually a very useful tool for evaluating fear in the market. Directly corresponding to the intense run up in 2013, the VIX has been crunched down into a very tight range for roughly a year and a half. Perhaps an appropriate analogy would be having a large hungry bear (selling) in a steel cage (QE) waiting to break out (end of taper). Also keep in mind that analysts are predicting earnings to start declining abroad in the near future for the first time since the crisis in 08.

(click to enlarge)Click to enlarge

Bottom Line

Last year I was conservatively bullish on the market and fortunately had full exposure. However valuations have now changed significantly and market sentiment is shifting into neutral gear while waiting for some foreshadowed or unforeseen catalyst. With that said investors may want to seek alternatives in "safe yield" or at least avoid maximum exposure to the correlated market. My friend has told me time and time again that a sin of omission (or not making money) is better than a sin of commission (losing it), and it's true.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.