Expect volatility to linger, serving as a drag on risk-adjusted returns.
That’s the message from Goldman, whose David Kostin notes that headed into Friday’s selloff, the S&P had posted a risk-adjusted return of -0.1% in 2020, in just the 27th percentile since 1950.
“The coronavirus catalyzed the sharpest bear market on record and drove one-month realized volatility to its highest level during the past 70 years, matching Black Monday”, Kostin writes, adding that one-month realized vol. topped out at 97 in early April, and has declined to 28 since. That’s still well above the long-term average of ~13.
In order to get a feel for what’s in store, Goldman looks at consensus 12-month price targets for S&P 500 stocks, and simply divides them by six-month option-implied volatility.
The results are not particularly encouraging.
Specifically, consensus is looking for a 9% gain for the median stock, and the options market “says” volatility in the back half of the year will be 39, down from H1’s harrowing experience, but still elevated.
The takeaway, Kostin writes, is that the “prospective risk-adjusted return equals just 0.15 compared with the long-term average risk-adjusted return of 0.91 for the aggregate index”.
You’ll note that tech is at the bottom, while energy is near the top. “Info Tech offers a slim 6% absolute upside to price target”, Kostin remarks, before suggesting that “could be explained by stale analyst estimates lingering after the dramatic rebound in sector share prices since the market bottom”.
Although energy represents an optically “compelling” opportunity in terms of the scope for a rally to reach targets, that comes with significant risk, for obvious reasons. Six-month implied there is 59%.
Kostin also suggests that value investors are looking at a potentially historic opportunity.
“The FY2 P/E multiple gap between the highest valuation and lowest valuation stocks stands at the 95th percentile since 1980”, he notes, adding that “this valuation gap has historically been a strong indicator of Value outperformance over long investment horizons, but a poor signal for near-term returns”.
That’s another way of saying what value investors know all too well — namely that the market is ostensibly offering up a chance to capitalize on an unsustainable valuation disparity, but it’s contingent on possessing the patience of a saint.
The problem, of course, is that in a world where there is seemingly no price investors won’t pay for a handful of growth stocks assumed to be synonymous with “the future” of the global economy, the “long term” never arrives for value investors.
Well … the main equity classes I’m looking to add at present are utilities, consumer staples, and healthcare with good dividends and better than average credit ratings.
The point made here is a very important one. To echo the 1984 WarGames film, the right move is not to play when the prospect risk adjusted return is so low.