BlackRock’s Koesterich: Is low volatility a sign of vulnerability?

Russ Koesterich, Chief Investment Strategist at BlackRock argues that low volatility may have pitfalls, but also unexpected winners.

Stocks advanced last week, reaching record highs. Stocks were supported by a flurry of activity on the mergers and acquisitions front, including AT&T Inc.’s $48 billion bid for DirecTV and Marathon Oil’s acquisition of Hess Corporation’s retail business. The Dow Jones Industrial Average rose 0.97% to 16,606, the S&P 500 was up 1.59% to 1,900 and the tech-heavy Nasdaq Composite climbed 2.86% to close the week at 4,185. The yield on the 10-year Treasury rose slightly from 2.52% to 2.53%, as its price correspondingly dipped.

In pushing stocks higher, investors looked past some mixed economic data. Not only did stocks advance, but volatility also fell to its lowest level in more than a year. Low volatility can have a downside, in that the market may be vulnerable to a slide should there be any outside shocks-a possibility with key elections taking place in Europe and Ukraine. While we would remain overweight equities, we would exercise a bit of caution in the near term and focus on areas of the market that offer good value and downside protection.

This year, the parts of the market that are struggling are generally those that ran up the most in 2013: biotech, Internet companies and U.S. retailers. Retailers are a particularly interesting case. This sector rose sharply in 2013 on optimism over an economic rebound, sending valuations up by roughly 30% over the past 18 months.

Today, however, U.S. consumption is not accelerating as fast as expected, despite an economy that is improving from its first quarter slump. Growth in retail sales is sluggish, rising barely 0.2% a month, roughly half the long-term average. (The exceptions are interest-rate-sensitive segments like autos, which have found support in the low-interest-rate environment.)

As sales have struggled, so have retailers. More evidence came last week as several retailers including Dick’s Sporting Goods (DKS), Staples (SPLS) and Best Buy (BBY) reported disappointing earnings or guidance. Given the lethargic nature of consumer spending, and still elevated valuations on retail stocks, we would remain cautious on retailers and other consumer discretionary companies. Instead, we would favor areas of the market like large- and mega-cap companies that offer better value and a potential buffer should volatility return.

Conversely, some of last year’s worst performers are proving more resilient, particularly those that offer some relative value. A case in point: emerging markets (EMs).

EM investors have recently had to contend with a growing list of geopolitical issues. In addition to last Sunday’s elections in Ukraine, investors are now wrestling with rising geopolitical risk in Asia.

In Thailand, the army chief took control of the country, declared martial law and suspended the constitution two days later. However, investors took the event in stride-perhaps because it was Thailand’s 12th military coup since 1932-and Thailand’s stock market only posted a small loss for the week.

Part of the reason for the measured response: EM valuations remain modest compared to developed markets. The price-to-earnings ratio for developed countries has risen nearly 40% over the past two years, while EMs are up a more moderate 20%. While EMs are not cheap per se, they offer relative value to developed markets, which helps explain why EMs have outperformed developed markets by roughly 4% so far in May.

In short, the fact that EM stocks have withstood the recent geopolitical risks supports the notion that, although they can be volatile, EM equities offer some relative value in a world in which many asset classes are priced for perfection.

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