Opportunity Amid Volatility

06/02/2010 10:41 am EST

Focus: MARKETS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, associate director of ETF research at Morningstar, says the recent market turmoil gives stock and bond investors opportunities if they can stomach the volatility.

Global investors have once again deemed that the US dollar is the reserve currency of the world, and US Treasuries are the safest play anywhere.

Ten-year Treasury yields have retreated back to around 3.3% after surpassing 4% yields for the first time in more than nine months back in April. While the Treasury rally has likely come from investors seeking capital preservation, income seekers have been investing elsewhere.

Relatively speaking, corporate credits in defensive sectors, such as health care, consumer products, and some industrial names, have been the beneficiaries of the declining credit quality of foreign sovereign issues (contagion fears in Europe). Corporate balance sheets seem to be on the mend, especially when compared with sovereign issues, so we’ve witnessed US corporate-credit spreads contract 2.9% over the past year.

This all fine and good if you have already established your fixed-income exposure, because it appears that the inevitable price drop of domestic bonds has been delayed further. However, those of you seeking to boost your bond exposure may be doing so at an inopportune time. If this is the path you are considering, we recommend sticking with the [investment grade corporate bonds] rather than running to Treasuries.

In the Hands-On Portfolio, we have been sitting on our 19% cash stake. We simply have not seen many pitches worth swinging at. While we think equities are fairly valued at the moment, we see little differentiation in valuations between sectors today. [However,] we think large-value and high-quality stocks offer the best opportunities today.

We would not hesitate to add [those kinds of stocks] if being fully invested were our ultimate goal, but we would like to keep some powder dry so we can pounce when other ideas materialize. A rise in volatility and a market correction would provide us such an opportunity.

The implied volatility of the S&P 500, as measured by [the Standard & Poor’s 500] VIX Short-Term Futures Total Return Index, recently spiked to 25. That’s a nearly perfect midpoint for the last 52 weeks, where we witnessed implied volatility fall from 35 one year ago to 15 [in April].

We’ve said the recent rally likely went too far too fast, and very few people (ourselves included) believed the economy was just fine. Government intervention across the globe simply spread the pain out over a longer time frame and transformed the agony into differing forms. Immediate bankruptcy for many firms is no longer the fear, [but] anemic growth and the fear of wealth redistribution through inflationary policies are as prevalent today as they were nine months ago.

Because we still have cash to deploy, we welcome the recent fears in the market with open arms. Hopefully, we’ll become fully invested over the next two months so we can enjoy the longer-term prospects uncertainty provides.

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