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Low Volatility Outperformance Reveals a “Risk-Off” Mindset for Investors

Over the past few months, the U.S. equity markets have been undulating inconclusively between 2050 and 2130. Understandably, investors are now asking “what’s next?” We’ve all been taught that the S&P 500’s performance in Q3 historically has been fairly anemic, and that August is among the worst performing months of the year. Indeed, since 1945 it ranks #10, behind February and September, posting an average price decline. Also, August has seen the second highest level of volatility since 1950, based on the number of days that the S&P 500 rose or fell by 1% or more, capturing an average of nearly 9% of all such days, versus October’s 10.6%.

The market itself may also be telling us that more volatility along with a disappointing overall price performance, lies ahead. When trying to ascertain a “risk-on” or “risk-off” environment, some investors compare the S&P 500 Consumer Discretionary Index (CD) with the Consumer Staples Index (CS). A still-better approach comes from monitoring the divergence between the S&P 500 High Beta Index (HB) and the S&P 500 Low Volatility Index (LV).

Weekly Relative Strength of S&P 500 High Beta vs. Low Volatility Index

To see which indicator (CD/CS or HB/LV) offered better risk on/risk off guidance, monthly price returns from 12/31/89 through 7/31/15 were evaluated, where the S&P 500’s return was captured whenever HB beat LV, but applying no change when LV beat HB. The same was done for CD and CS. Obviously, there is no way of knowing in advance if HB or CD would beat their defensive counterpart. The interest was in seeing which pair delivered superior results whenever their market timing signals were “on” or “off.” As a result of this hypothetical market timing study, the HB/LV pairing did a much better job than CD/CS.

As of July 31, the relative strength of the S&P 500 High Beta Index vs. the Low Volatility Index shows that investors have been in a “risk-off” mindset since the final new high was established in May. In the month ahead, investors may therefore be more inclined to focus on their tans than on their portfolios.

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