While I believe that market volatility will be higher in the second half of the year, I believe that volatility is currently too high. In fact, I believe that the panic is overdone unless you believe we’re headed back into another banking crisis or severe recession, both of which I believe are unlikely. 

Back in May, the VIX Index -- otherwise known as the fear gauge -- was trading at around 17.50 and I highlighted that it looked too low. Now, however, according to my latest analysis, volatility levels in the 40-plus range are way out of line compared to where leading indicators suggest they should be and fears about equity markets appear extreme relative to credit market conditions. According to my model-based analysis, volatility should currently be in the mid- to high-20’s, slightly higher than where it should have been in May, and not above 40.

Volatility tends to move with market momentum, credit spreads and leading economic indicators. My analysis compares current levels of volatility with these fundamental drivers and assigns a “fair value” for the VIX. And while all three of these drivers have deteriorated recently, none are suggesting that volatility should be this high.

For example, credit markets have seen spreads widen. However, recent widening spreads have been relatively small compared to the sell-off in 2008. Today the spread between Baa and Aaa bonds is 97 basis points, in-line with the long-term average. In contrast, at the peak of the 2008 crisis, spreads were well above 300 basis points. In other words, equity market fear appears extreme relative to credit market conditions.

Similarly, while we expect very slow and potentially negative growth over the next one to two quarters, current volatility levels are way out-of-line compared to where leading indicators suggest they should be.

What does this mean for investors? While we still believe investors should remain defensive, the current selling looks extreme and the recent spike in volatility appears too high. Investors should consider adding selectively to their equity exposure, while still maintaining a defensive posture.

Source:  Bloomberg

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This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

According to the department’s Bureau of Labor Statistics, 18,000 new jobs were created in June, well below consensus estimates of more than 100,000 and essentially unchanged from May.

In addition, the department said the unemployment rate came in at a higher-than-expected 9.2%, also essentially unchanged from 9.1% in May and the highest level this year. Other details of the report were also disappointing. The fact that the labor force participation rate continues to decline and is now at its lowest level since 1984 was also particularly surprising.

Like last month’s similar figures, the new non-farm payroll report provides even more data points hammering home the fact that this recovery is unusual. More than two years into the recovery, job creation remains anemic, the unemployment rate high and the number of people engaged in the labor force still dropping.

Why is this recovery different? Unlike a typical recession, the latest downturn was not caused by an overheating economy and tight monetary policy but instead by the bursting of a credit bubble. And as typically happens after such events, the economy and the labor market are slow to recover.

Again, while we do not believe that the US economy is heading back into a recession, we do expect that the recovery, particularly in jobs, will be slow and continue to disappoint investors.

So assuming a slow recovery, what are the investment implications? The weak labor market is just one of many headwinds facing the US consumer. In fact, we don’t expect consumer spending to pick up materially over the next six to 12 months. Such recent weakness in consumption continues to be a negative for companies or ETFs levered to US consumption and particularly for US retailers, which we’ll share more about in a future post.

In addition, as we pointed out last month, recent non-farm payroll figures are also signs that inflation is likely not going to be a serious threat this year or arguably next year.

Source: Bloomberg

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Historically, returns to equities have been consistently higher than other asset classes.  This is to be expected from financial theory, as equities are more volatile than bonds or cash.  On a real or inflation-adjusted return basis, equities have also outperformed – if you include emerging markets – other asset classes throughout most regimes.  The major risk to equities remains a low growth/high inflation or ‘stagflation’ environment.

In addition to their long-term track record, today equities have another advantage: they are reasonably priced relative to other financial assets.  Many investors remain underweight stocks following the dismal performance of the asset class during the previous decade.  The period from 2000-2009 represented the worst 10-year stretch for equities since the 1930s.  We would argue the principal cause of last decade’s negative real returns was the absurd valuations of most equity markets in early 2000.  While global stocks are no longer as cheap as they were at the 2009 bottom, current valuations are at or modestly below their long-term average.  This suggests that multiple contractions, of the type we witnessed over the previous ten years, should not be an impediment to global equity returns over the coming years.  While investors need to be modest in their expectations, on a relative basis equities are likely to produce reasonable long-term returns.

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Read and listen to the full iShares Market Perspectives for June 2011.

Source: Bloomberg

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