Picking Stocks for Volatile Times
While it's unclear what the long-term effects of rising interest rates will be for the stock market, the short-term impact is already being felt: rising volatility.
You can measure stock-market volatility in various ways, but the simplest is to just rely on your gut. In eight of nine trading days from June 5 through June 15, the Dow Jones industrial average shot up or fell by 70 points or more, testing the queasiness of investors. On five of those days, the Dow bounced up or down by at least 129 points. That type of volatility hasn't been felt since the start of the Iraq war in March 2003.
Of course, there are other more technical ways to measure gyrations in the market. The most common gauge of volatility is the Chicago Board Options Exchange Volatility Index, or VIX as it's commonly known. The VIX measures volatility based on trading of Standard & Poor's 500 options contracts.
After peaking at a reading above 40 in the late '90s, the VIX has fallen significantly. Since the end of the bear market in 2002, the VIX has hovered at just over 10. That's a smooth ride for stocks.
But after long-term bond yields spiked this month on better-than-expected economic news, the VIX jumped to a reading of around 15. And Richard Bernstein, chief investment strategist for Merrill Lynch, noted in a recent investment strategy report that "the VIX index looks to be heading toward 16," implying that the market should expect more rockiness ahead.
"Everyone should expect increased volatility," says Duncan Richardson, chief equity investment officer at Eaton Vance. "But it's not the end of the world."
Indeed, despite the recent gyrations, many strategists expect the bull market to continue. Bernstein predicts the S&P 500 could gain 7 percent or so over the next 12 months. Tobias Levkovich, chief U.S. equity strategist at Citigroup Investment Research, thinks the S&P 500, which is currently trading at around 1530, will finish the year at around 1600.
The fact is rising volatility doesn't mean that stocks will necessarily lose ground. But it does mean that investors need to change their approach to equities. In the past few years, risk has been almost an afterthought, as investors got rich by diving head first into speculative emerging-markets stocks and small-company domestic shares.
The winning formula for stock investing is likely to change, market strategists say, to a much more conservative mix that's mindful of heightened volatility.
Size will matter. Increased volatility is likely to sour investors on risky types of stocks, since those shares usually bounce the most. Conversely, investors will probably gravitate toward the large, stable, industry-leading companies that are better equipped to weather a market storm, says Richardson. This means large-capitalization "blue chip" stocks, which have been leading the stock market so far this year, are likely to remain the place to be.
Dividends will matter. In a volatile market, investors should expect some short-term losses in their portfolios. But one way to minimize those losses is to invest in stocks that pay out handsome dividends. Dividends in essence pay investors to wait out the market volatility. And the dividends themselves, which are a key but often overlooked component of total returns, might keep your portfolio above water even if your stock prices are falling.
Sectors will matter. When volatility rises, certain sectors of the economy have historically performed better than others. Levkovich found that over the past 20 years, two of the best sectors to invest in during times of rising volatility were technology and pharmaceutical stocks. By contrast, industry groups whose stocks perform poorly in volatile times include utilities, consumer services, and retailers. So, when the stock market gets rocky, those are sectors to avoid.
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