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Two 'Tails' of Risk in the Stock Market
The U.S. stock market has essentially divided into two parts, with the return difference between these two groups at greater than 80%. Is this return differential justified? Or does this mean that the market isn’t pricing in risk correctly? Head of Quantitative Strategies Michael Hunstad, Ph.D., explores the issue.
The US equity market so far this year has essentially divided into two parts. First are the riskiest stocks with the highest volatility in market beta. Second are their less risky counterparts, with more stable cash flows and relatively low beta.
Now, the return difference between these two groups is greater than 80%. Should it be? Or does this mean that the market isn't pricing risk correctly? Let's take a closer look.
The first four months of 2021 have been euphoric for most equity markets. US benchmarks are up more than 12%. But among individual stocks, the distribution of returns has been far from even.
The high beta stocks have risen nearly 25%, while the low beta stocks have barely budged. Importantly, many segments of the market are pricing in economic conditions equal to or better than what they were pre-pandemic. For example, the market capitalization of the travel hotel and restaurant industries is higher now than they were at the end of 2019.
Energy stocks have surged as investors expect oil prices to rally with economic recovery. Banks and other companies that benefit from higher interest rates have also run up, as investors see the recovery creating enough inflation to push up rates. And finally, higher price to earnings multiples for growth stocks assume very strong economic expectations.
But the market may not be thinking through all the risks that still linger. This includes the jump in global COVID-19 cases, uncertainty surrounding monetary and tax policy, and more regulation on technology companies. All these risks have been largely ignored.
This euphoria has made riskier stocks very expensive. In contrast, higher quality, lower risk stocks-- those with better profitability, cash flows, and balance sheets-- remain quite cheap. Importantly, recall that equity markets can quickly shift focus and reprice risk. In fact, that repricing may have already begun, as higher quality stocks outperformed in March and April.
We suspect that investors are starting to appreciate how high-quality stocks potentially limit losses during volatility shocks and have historically performed well amid inflation. We think that higher quality is well positioned if rosy economic expectations don't fully materialize. But we remain sanguine about equity markets overall. We feel some parts of the market are priced to perfection.
But there are still many potential sources of volatility looming large. We suggest insulating your equity portfolios from potentially violent repricing through a higher quality posture.