Why Low-Volatility Stocks Might Not Work in the Next Crash

Even as the S&P 500 (SNPINDEX: ^GSPC  ) has continued to set new all-time record highs recently, many investors fear that the end of the bull market that began way back in early 2009 could be approaching. One strategy that many investors use to protect themselves against pullbacks is to focus on stocks that have lower volatility than the overall market, counting on them to fall more gently than the S&P 500 in the event of trouble. Yet given how many investors are buying Johnson & Johnson (NYSE: JNJ  ) , McDonald's (NYSE: MCD  ) , and other low-beta stock names, their lofty share prices might not provide as much resistance to a market drop as they have in the past.

Missing the bull
The trade-off that investors accept with low-volatility stocks is lagging behind the overall market during periods of strong performance. We've definitely seen that over the past year, with one major low-volatility ETF providing less than half the return of the S&P:

USMV Total Return Price Chart

Total Return Price data by YCharts.

Of course, proponents of low-volatility strategies argue that they're willing to accept these periods of underperformance if it helps them preserve capital when stock markets fall. But there are a couple of arguments against that conclusion as well.

First of all, when you look back at the market's pullback earlier this year, you can see that low-volatility stocks lost almost as much ground on a percentage basis as the overall market. If an investment rises more slowly than the broad market but falls just as much, then it will consistently underperform not just in bull markets but in all market environments.

Source: McDonald's.

More importantly, though, when you look at the valuations of low-volatility stocks, they tend to be higher than those of the overall market, reflecting investor demand. For instance, the low-volatility ETF pictured above has an average component P/E ratio of more than 23 as of March 31, which is higher than the 22 multiple that the ETF's investment manager provides for its S&P 500 exchange-traded fund. Similarly, Johnson & Johnson and McDonald's both trade at fairly high multiples. Their share prices reflect their popularity, but it also gives them more room to fall in a down market and could prevent them from having their usual defensive tendencies.

You shouldn't give up on looking for ways to reduce your risk to acceptable levels if you're nervous about the overall market. But the best strategy looks beyond simple rules of thumb to look for true value stocks with a margin of safety in the event of a stock market crash. Otherwise, you could just find yourself being one of the crowd suffering losses in the next bear market.

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  • Report this Comment On April 23, 2014, at 7:28 PM, JeffryClarke wrote:

    I think this is one of the more interesting trends in the market that isn't being talked about much. High dividend yield and low volatility stocks are simply overvalued on average. So yeah the stocks are safe but they're also set up to underperform.

  • Report this Comment On April 25, 2014, at 2:35 PM, TraderFool wrote:

    Well, the interesting thing about JNJ is that over the 2 Bear Markets of 2000-2003, and 2007-2009, it held its value quite well, but personally, I would prefer cash better then, as you could buy some really great high Beta stocks (instead of JNJ) in 2003 and 2009, and made a killing (and also leveraged instruments of course). JNJ price didn't quite move at all from 2002 to 2012, with peak prices around $65 .... 10 years of fairly flattish prices isn't my cup of tea ...

  • Report this Comment On April 27, 2014, at 8:11 PM, TigerPack1 wrote:

    On a 5-year trailing basis, JNJ and MCD are around 20x EPS. Against an S&P 500 or Russell 2000 or Nasdaq 5-year trailing average of 25+ P/Es at current pricing, I would not say either has high multiples. On a forward basis 2014 multiples for the two are about 16x for 2014 and 15x for 2015. They have fairly decent odds of hitting those Wall Street targets, even during a minor recession.

    Given they will have better forward earnings given a recession period, vs. the overall more cyclical earnings dependent market, both should outperform nicely in a typical 25%-30% bear market period over 3-6 months. I would guess both would hold up well under this scenario, perhaps falling just 10%-15% in price.

    Given a 40%-50% market crash like 1987 or 1929 over 6-7 weeks, I would guesstimate these two would fall in the 30%-40% range. True crash patterns punish all stocks, this is absolutely a fact. Even gold miners crashed in 1929 and 1987 at percentages close to the overall market.

    The best way to prepare your portfolio for a crash is either holding high levels of cash or hedging your longs with (1) put options of some sort or (2) inverse ETF strategies. I prefer the inverse ETF strategy and run portfolios with little, no or negative net long positions today. The ETF decay is not much fun, but the upside is being able to hold outperforming longs.

    I do not own either JNJ or MCD currently, but would consider them given a 10% to 15% sale price.

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Dan Caplinger

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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Related Tickers

9/1/2015 2:09 PM
^GSPC $1923.10 Down -49.08 -2.49%
S&P 500 INDEX CAPS Rating: No stars
JNJ $91.83 Down -2.15 -2.29%
Johnson & Johnson CAPS Rating: ****
MCD $93.52 Down -1.50 -1.58%
McDonald's CAPS Rating: ***