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Asset Allocation | Equities

Positioning Portfolios for Volatility

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Investors have enjoyed an unusual degree of stability for the environment we live in. When Citi analysts look at implied volatility versus realized volatility (what people expect to happen versus what is happening to asset prices), there is a disconnect. A high level of implied volatility often implies investors are fearful, positioned cautiously, and hedging downside risk. This is the type of behaviour that can make for stronger equity market gains. However, when markets have been strong in the face of uncertainty, the difference in implied versus actual volatility presages periods when more volatility may be realized.

 

 

Sources of Expected Higher Volatility

US Election – The election is a major source of higher stock market volatility. Implied volatility in US equity markets is priced about 12% higher by the November 3rd US election day and then rises another 3% in the month beyond.

 

Questionable Fiscal Support for the US Economy – Citi analysts have assumed further US Congressional action to support individuals, businesses and municipalities based on the prior 50 years of history where such support was delivered. Yet, as the election draws closer, the likelihood of such support becomes smaller.

 

The Limitations of Central Banks - Central bankers have succeeded in avoiding a self-reinforcing spiral of downward economic momentum in response to COVID-19 by reducing key policy rates toward zero or below. Low rates can create asset bubbles by making it easier to discount future earnings growth (and revenue growth) to justify higher stock prices. But when COVID-19 ends and that growth does not materialize, asset prices may quickly and painfully adjust.

 

 

How to Position for Volatility?

Seek balanced core portfolios. Given the current gains in defensive shares, including technology, many portfolios are not balanced. Therefore, rotating portfolios into cyclical shares, small and mid-cap stocks, under-performing markets and more “value-oriented” growth assets makes sense. At the most basic level, investors need to avoid market timing. Do not assume that huge gains in concentrated investments are “easy” to sustain.

 

This is a New Economic Cycle and it is just six months old. The larger economic recovery is still almost entirely ahead. The “unloved” COVID-19 cyclical sectors are likely to have stronger returns over the next 12-18 months when markets normalize. Underweighting expensive fixed income markets with negligible or negative yields may be beneficial to portfolios.

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