Volatility is back.
But, given that the last time we saw the VIX above 30 was 2011, clients may not remember what it feels like. The volatility index closed at 40.74 Monday, up 45.34% since Friday.
Advisors shouldn’t “overreact when we see more normal volatility,” says Stephen Lingard, SVP and portfolio manager, Franklin Templeton Solutions. In fact, he says, “We like some volatility. It will provide some more opportunities.”
Mike O’Brien, managing director at TD Asset Management, says Monday’s events are not a reason for panic, and calls the dips an aftershock from the 2008 crisis. “On the whole, we’re moving in the right direction — just not as fast as we’d like.”
Read: Global markets plunge
At close Monday, the Dow Jones was down 588.47 or 3.58%, the S&P/TSX Composite was down 420.93 (3.12%), and the S&P 500 was down 77.68 (3.94%). Lingard says it’s interesting that the TSX outperformed, adding it may be a reflection of sell-off exhaustion with regards to energy stocks.
We asked experts how to react to Monday’s events.
Why did the sell-off happen?
Two main reasons: Bad Chinese economic news and the potential for the U.S. to raise rates in September.
China
The Shanghai composite closed down 8.5% on Friday, which was its biggest one-day fall since 2007. “A lot people were hoping the sell-off would catch the attention of Chinese policy makers,” says O’Brien. “There were expectations that we might get a reserve requirement ratio (RRR) cut or an interest-rate cut from China, signaling that officials were trying to address the growth issue. And when you didn’t get anything concrete happen over the weekend, a lot of people came out [bearish] this morning.”
Read: Chinese stocks suffer biggest drop in eight years
Lingard says the lack of action may be a good sign. “The fact that China didn’t cut rates or reduce the RRR suggests they have policy room, and the slowdown in their eyes is not as bad as everyone suggests. The bears have seized on the move last week to weaken the renminbi, but it’s what Western markets were asking for years.”
He points out China’s growth is still three times higher than that of Western economies. “The nature of their growth is changing; it’s not as commodity-intensive,” he says. And, while markets reacted negatively to poor manufacturing data, “the flipside is that services are growing at a healthy clip.” He adds, “Our base case is not a hard landing.”
U.S.
“The chances of a rate hike are inevitable in the near-term,” says Craig Fehr, an investment strategist with Edward Jones. “The exact month is semantics. But the broader conclusion is the Fed is becoming more comfortable with the outlook for growth and sees the economy as being able to withstand a hike.”
Lingard is hopeful the Fed can raise rates soon. “If the Fed can normalize, we see that as very positive for markets. The U.S. economy is at trend or slightly below.”
Read: High correlation between Canadian, emerging markets
Was Monday’s drop warranted?
Some of it, says O’Brien. “If fears about China and the Fed had been in the context of a cheap market, maybe it wouldn’t have been as severe. But some stocks have had great runs, and it’s understandable that markets have reacted this way.”
But, he adds, “Our base case is that this was a correction, a pause; not something more dire.”
Fehr agrees. “Outside the Chinese economy, I don’t see the negative impact to the Canadian and U.S. economies and corporate profitability that’s being reflected in the downdraft of the markets today. We’re getting a bigger knee-jerk reaction that is being supported by the fundamentals, which creates opportunities for long-term investors.”
Read: Should pension funds put the brakes on low-volatility strategies?
Where are the opportunities?
Consider highly valued stocks, such as U.S. equities, with strong fundamentals, says Lingard. “We’re also seeing commodity producers like Canada, Australia and emerging markets get cheaper. At some point, there could be value emerging in those beaten-up areas, much like we played Japan over the last two years. It was a cheap market and we were buying into it when investors were running the other way.”
He also suggests investors who are underweight emerging market equities add to their positions, but not to the point of overweighting. “Broadly speaking, they’re underowned because performance has been so bad.” But he says a lot of negative news is priced in. “We see better times ahead.”
Still, he remains cautious. “Areas like Brazil and Russia [are] getting cheap, but we’re still nervous about political situations.”
He’s been neutral equities since the summer, but isn’t afraid to deploy his cash to buy attractive stocks.
Read: Money managers worry about emerging markets
O’Brien is optimistic about Canadian financials and commodities over a three- to five-year horizon. He says banks are trading below 10x earnings, and many have dividend yields of 4% to 5%. He also notes that they’re dividend raisers: BNS, for instance, has had dividend increases in 43 of the last 45 years.
He also likes insurers: “Their capital ratios and balance sheets are shored up. They have nice global footprints. Those companies are trading at 10x to 12x earnings, which is pretty reasonable.”
As for energy, O’Brien says the right price for oil is between $75 to $90. He says to look for “companies with balance sheets to last through this period of low oil prices,” which he pinpoints at six to 18 months. “You don’t have to go down the quality curve to find something that will have a good return over a three- to five-year period.”
Finally, in light of the U.S. recovery, Fehr likes U.S. consumer discretionary, utilities, healthcare, and telecom thanks to their “steadier streams of earnings.” He adds, “There are opportunities in this market that are overshadowed by the severity of the downturn.”
This story originally appeared on our sister site, Advisor.ca.