- Investors have often treated volatility as their enemy, as it's usually associated with falling stock prices.
- But the Federal Reserve's near-decade-long practice of quantitative easing has turned volatility into an investor's best friend, according to Jim Paulsen of The Leuthold Group.
- Here's how investors can take advantage of a likely upcoming scenario where volatility pays off.
- Sign up here for our daily newsletter, 10 Things Before the Opening Bell.
Volatility can be a scary word on Wall Street, as it likely brings back painful memories for investors who experienced swift and sharp price declines in the stock market.
Whether it was the 1987 crash, the popping of the dot-com bubble, or the 2008-2009 financial crisis, a spike in volatility has scarred investors and conditioned them to panic for the exits.
But according to Jim Paulsen, chief investment strategist of the Leuthold Group, a certain scenario of market volatility can be an investor's best friend, as forward returns have historically proven to be strong for stocks.
In a recent client note, Paulsen laid out the environment where investors should get bullish on stocks amid a rise in volatility, primarily thanks to the Federal Reserve's ongoing quantitative easing policies.
"Investors should be aware of the way the Fed has altered the investment landscape, and, when available, be prepared to exploit 'valuable volatility," Paulsen explained. "Massive and constant use of QE has essentially squashed bond market volatility, creating far more frequent opportunities for stock investors to exploit a specific 'valuable' volatility."
Paulsen's profitable setup for stocks is predicated on bond volatility staying subdued while equity volatility rises, according to the note. Since the Fed began quantitative easing measures, bond volatility has been below average 97% of the time. Prior to quantitative easing, bond volatility was below average just 31% of the time.
When volatility jumps for stocks but remains subdued for bonds, market performance more than doubles other periods of time on a 1-month forward, 3-month forward, and 6-month forward time frame, according to the note.
"The combination of an elevated wall of worry for stocks with the perception of bond-market stability is a home run for stock investors. Al least since 1990, this is a 'volatility' worth buying!" said Paulsen. And recent actions from the Fed has increased the frequency of this scenario playing out.
Prior to 2012, the frequency of having below-average bond volatility with above average stock volatility was just 8.8%. But after 2012, "the Fed has provided the stock market with this gift almost 20% of the time!," the note said.
Paulsen explained that quantitative easing policies has likely contributed to both aspects of the volatility scenario, has the easy money policies helped depress bond volatility "while also contributing to a wall of worry among stock investors due to the potential ills of overuse and abuse of monetary policies," Paulsen said.
With bond volatility still subdued, and the VIX just two points below its average, a valuable period of volatility could be right around the corner as the VIX index "will likely eventually slip back above average and present equity investors with another opportunity to enjoy Valuable volatility!," Paulsen concluded.
Paulsen measures the volatility of stocks with the VIX index, and the volatility of bonds with the MOVE Index.