Volatility Breeds Opportunity

Written by our Managing Director: Amit R. Stavinsky-6/4/2015
Why Invest in a Volatile Market?

Uncertainty breeds volatility and volatility breeds uncertainty. This is the vicious cycle investors in financial markets should expect from now on to the end of the year.

Investors should be aware of heightened bond, stock, commodity and currency market volatility, mostly as a result of interest rate uncertainty. 1Yesterday, 10-year U.S Treasury yields climbed to the highest levels since last October of near 2.4% from about 1.4%. Also, in Europe 10-year German bond yields which on April 17 returned about 5 basis points, moved up to an eight- month high yesterday of 0.91 percent.

This year’s gains in global bonds evaporated as the European Central Bank chief Mario Draghi forecasted faster Euro-era inflation and continued market volatility. German bunds are at the epicenter of a rout in world bonds, and with lower interest rate differentials between bunds and Treasuries, traders are piling back into the Euro from the dollar. 2The yield gap between German bunds and U.S Treasuries narrowed to the least since early February, at 144 basis points. The 19-nation shared currency surged 0.6% percent to $1.1333 reaching the strongest level since May 18.

Gold prices are also declining thus far this week, mostly as a result of heightened expectations for increase in the Fed Funds Rate by the Federal Reserve’s Board toward the end of the year. Gold, with “zero coupon interest payments” is perceived by market participants to be a less attractive investment vehicle during times of rising interest rates, and extremely low inflation rates. Additionally, some of the contributing factors to declining oil prices this week are the persisting inventory glut of oil, OPEC members’ meeting tomorrow, no action thus far by its participants to reduce production, and the weakening in the dollar priced commodity.

Lastly, the continued Greek standoff with international creditors, extended equity markets in their 5th back to back bull market 3selling at average market multiples of 18.53 times earnings, and tomorrow’s release of the May U.S nonfarm payroll report could all bring about additional uncertainty to an already nervous financial market. Greece, at this point doesn’t have access to additional capital and is facing imminent payments in June to the IMF totaling 1.5 billion Euros.

So what should investors do? In case some of us are contrarian in nature, volatility can also breed opportunity. For starters, the Federal Reserves’ Board being data dependent might just decide to either raise the Fed Funds rate in a gradual minute manner or to execute a one off Fed Funds interest rate increase and “go away.” Therefore, investors should attempt to capitalize on any bond market weakness today by gradually but aggressively picking up either taxable or tax free Municipal bond offerings where the spread over Treasury yields is attractive; and so, these bonds are priced at attractive discount levels to the high grade Municipal bond market.

In addition, the recent bond market volatility in Europe likely won’t deter the Central Bank Chief Mario Draghi from continuing to fulfill the bank’s commitment of purchasing 65 billion Euros per month of government securities. This in turn might also put a floor on any European bond market route; and hence, present buying opportunities for value investors.

In my view, a value discipline of daily analysis for the optimum risk reward sweet spot along the yield curve, taking into account credit worthiness, coupon, and duration should enable investors vis a vis the current bond market volatility to gradually employ available cash balances in their households’ accounts. In addition, investors should also consider taking advantage of high quality growth businesses at attractive prices. For example, 4currently the total cash returns for the S&P 500 companies approximates 4.5%. Of these companies, net equity buy backs and dividend yields are approximately 2.5% and 2% consecutively. It is a remarkable level, considering that it stands above the yield on investment grade bonds.

1Bloomberg 06/04/2015
2Bloomberg 06/04/2015
3Bloomberg 06/04/2015
4Credit Suisse, Global Equity Strategy December 2014