The Rocky Road Ahead This Year

Includes: ACWV, HDV
by: Russ Koesterich, CFA

Back in February I warned of an eerie quiet that had settled over the market. The Chicago Board Options Exchange Volatility Index (VIX), an index often referred to as the “fear gauge,” had hit its lowest level since July. At the time, I argued that level was much too low and investors should start to prepare for rising volatility.

Well, fast forward four months. The eerie quiet has lifted, the VIX is now in the low 20s, and I expect this heightened volatility to continue for the remainder of the year. Here are three reasons why:

1.) Near-term investor expectations of a weaker economy. Lately, a number of weaker-than-expected economic reports have suggested that every country from China to the United States is confronting weaker growth. As the harsh reality of the worst recovery in the post-World War II period keeps extinguishing whatever optimism investors are able to generate, investors are downwardly revising their expectations for both the global and US economies. Going forward, this is likely to keep markets volatile.

2.) A collapse in momentum. Market momentum is one measure of overall market sentiment. Traditionally, as momentum drops, investors tend to decrease their positions or put on hedges, which in turn causes a rise in market volatility. Over the last six months, we’ve witnessed just such a drop in momentum, which is likely to continue. For instance, as of late June, the six-month momentum for the S&P 500 was barely 5%, down from 34% in late March.

3.) Rising credit spreads. We are currently in an economic environment of rising credit spreads. While spreads between various credit instruments have so far risen only modestly (and not enough to signal a market meltdown), rising spread environments typically coincide with increases in equity market volatility.

What could change this view? Market volatility could end up being higher than I expect if the situation in Europe deteriorates further. But volatility could be lower if investor sentiment shifts to more accurately reflect market fundamentals, which haven’t slipped as much as current investor pessimism would suggest, and if leading indicators remain stable.

In the meantime, I believe that investors should continue to favor investments that potentially offer some downside protection while still potentially producing a reasonable yield and allowing for participation in market gains. Such investment options include dividend-paying stock funds such as the iShares High Dividend Equity Fund (NYSEARCA:HDV) and minimum volatility funds such as the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV).

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