What to Do in the Stock Markets If Volatility Suddenly Spikes

 | May 26, 2017 | 9:00 AM EDT
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Calculus geeks, rejoice. Here's a quote summing up neatly what investors should pay attention to: "For markets, the second derivative of economic activity is frequently more important than the first."

This comes from a recent report by Oxford Economics' Director of Global Macro Strategy Gaurav Saroliya and, in non-math language, it means that the acceleration of the recovery is more important than the recovery itself.

While purchasing managers' indexes for all major economies are above the 50 number that separates contraction from expansion, they aren't growing very fast. For major economies apart from the eurozone -- which is in an earlier cycle, as quantitative easing started later there than elsewhere -- the latest PMIs are not much higher than their six-month averages. For China and the U.S., they are in fact lower.

At the same time, volatility has fallen steadily for a range of asset classes, "helping to richen risk-asset valuations, especially in equities and credit," Saroliya said. Across asset classes, three-year historical volatility is lower than median levels.

The divergence between market sentiment and macroeconomic risks is pronounced, Saroliya warned, saying that "vulnerability to shocks is especially high."

He recommends investors to go underweight U.S. equities and corporate bonds. It seems they are already doing so, at least when it comes to stocks. Data from Lipper quoted by Reuters showed that U.S. equity funds saw their second-largest outflow of the year, totatling $10.1 billion, in the week that ended on May 24.

Ever since Emmanuel Macron made it in the second round of the presidential election in France against his rival, extremist Marine Le Pen, buying European stocks has been a safe bet. They were undervalued compared to the U.S., while earnings and general economic conditions are improving due to the effects of the European Central Bank's quantitative easing finally bearing fruit.

Such has been the rush into European equities after Macron's victory that they are no longer all that cheap. But Saroliya still recommended buying European and select emerging markets equities on any dips.

In Europe, a combination of valuations that are still relatively cheaper than the U.S., strong earnings growth acceleration of 36% year on year in the first quarter for the Stoxx 600 and receding political risks continue to make equities attractive, he said.

As for emerging markets, differentiation is crucial. In the equities space, Saroliya said Turkey as well as several countries in Central and Eastern Europe and in the Middle East look attractive based on valuations and improving growth prospects.

Another emerging stock market that could do well is Mexico. It is not cheap, but "the high reliance on domestic sectors and the likelihood of a cyclical recovery should maintain the momentum over the next six months," he said.

The low volatility witnessed in the markets could be a sign of complacency. But at the same time, as Bob Lang wrote earlier this week for Real Money, when volatility spikes it offers great buying opportunities.

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