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:
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.
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.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Johnson & Johnson and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.