Guess what? Cross-asset vol. is suppressed. Who knew, right?
How should you capitalize? Well, you know how the old saying is “don’t quit your day job”? Yeah, so in the current environment, the opposite applies. If you are a Target manager, you should actually “quit your day job” in favor of moving in and out of VIX ETPs all day long on your way to ensuring that thanks to the NY Times, you will forever be remembered as the poster child for the 2017 equity bubble.
Of course that’s the extreme case. You could just continue to chase into riskier assets, ride the carry bandwagon, and sell yourself some vol. for a little extra yield enhancement. One thing’s for sure, you damn sure can’t try to be a hero by betting against this self-fulfilling prophecy because that’s a one-way ticket to underperformance in a world where change has become impossible.
Anyway, Goldman wants you to know that with “average cross-asset 3-month realized volatility ranking in just the 6th percentile versus the past 10 years” and with “the entire term structure implying that equity volatility will remain below its historical average,” minimum volatility strategies in equities are not the way to go. To wit:
Minimum volatility strategies have lagged the S&P 500 YTD, consistent with historical underperformance during low vol regimes. The MSCI US Min Vol ETF has seen $0.7 bn in inflows YTD but has lagged the S&P 500 by 240 bp (18% vs. 21%). Going forward, we recommend investors eschew min vol strategies.
Instead, Goldman thinks you should focus on stocks with high prospective Sharpe ratios. Consider this bit of additional color:
Our High Sharpe Ratio basket typically outperforms S&P 500 and min vol strategies on both an absolute and risk-adjusted basis in low vol environments. The basket consists of an equal-weighted, sector neutral portfolio of the 50 S&P 500 stocks with the highest “prospective Sharpe Ratios.” We define prospective Sharpe Ratios as consensus price targets divided by 6-month implied volatility. When 6-month realized vol has been less than or equal to 12, [the basket] has beaten min vol on an absolute basis during 73% of rolling six-month periods since 1999 (Exhibit 1):
So far this year, that basket hasn’t really outperformed the broad market (+2% versus the S&P’s performance). The reason, according to Goldman, is that “laggards often screen into the High Sharpe Ratio basket because of large expected upside to analyst price targets.”
Go it. So by extension, that basket will be negatively correlated to momentum and if you think about what’s happened in terms of the recent rotation out of momentum catalyzed in part by optimism on the tax bill (which will not benefit tech as much as it will other sectors), what you come away with is the conclusion that if the tax bill passes and the rotation continues, Goldman’s Sharpe ratio basket will outperform. Sure enough:
The recent rise in tax reform odds sparked a 6% reversal of our momentum factor while our High Sharpe Ratio basket beat the S&P 500 by 160 bp (+4.3% vs. +2.7%).
Ok, so the obvious question here is this: “what’s in that basket?” Well, broadly speaking, Goldman notes that relative to the S&P, the median stock in the rebalanced basket “offers 3x the expected return (+21% vs. +6%), has similar 6-month implied volatility (26 vs. 22), and trades at a P/E discount (17x vs 19x).” Here’s the list:
There you go. Take that for whatever it’s worth and for God’s sake, spare us the “Goldman must have ulterior motives for presenting this list” bit. It’s just a basket of stocks based on some screens. It’s not a nefarious plot to deceive anyone or prop up the prop desk, ok?
