Volatility and value in equities

Wild swings in equity prices and low investor confidence in the stock market has radically changed the landscape for UK corporates. There has been heavy selling of shares, coupled with the prospect of higher demand for corporate bonds as many pension funds shift to higher bond weightings, accelerating a trend that has been happening for the past five years or so.

As share prices drift or fall, sponsoring companies also face the challenge of weakened short-term solvency in their pension fund and, on top of this, a stricter accounting standard, FRS 17. Against this backdrop, the outlook for equities is of paramount importance for the UK corporate sector.

There are two key aspects of equity markets that may give an insight into the characteristics of future equity returns. These are the current yield and volatility of the UK equity market.

In times of volatile markets, it is easy to lose sight of the fundamentals of investing. Pension plans are long-term investments so the basis for many ongoing actuarial valuations will be the yield on index-linked gilts, and the yield on UK equities (as measured by the FT All Share). The left-hand graph shows the last ten years’ history of these yields (note there was a change from gross to net equity yields in May 1998).

The graph shows the difference between the yields has typically been in the range 0 to 0.5% (equities higher).

The difference between the yields has typically been in the range 0 to 0.5% (equities higher). The current difference (1.25%) is the highest over the last 10 years – even allowing for the change from gross to net dividends. It is probably fair to say that many actuaries would now consider equities to be cheap relative to index-linked bonds – at least when measured on a income basis over the long term.

Volatility is not inherently bad.

It is the price equity investors pay for their risk premium. No volatility would lead to a lower expectation of future return.

The markets feel more volatile now than they have been over the last ten years, but are they?

The graph on the right shows the experienced volatility of the FTSE-100 and the S&P500 over the past ten years (rolling one year, annualised). For reference, the very long-term average volatility of developed stock markets has tended to be just below 15%. In the absence of dramatic changes to economies, or the levels of gearing in companies, we see no strong reasons why – in the long term – future volatility should not be consistent with the long-term past.

Another way of looking at volatility is to consider the price the market demands to take equity risk off your hands. Information from the options market backs up the conclusion from graph on the right, that equity markets have increased in volatility over the last four years.

This is big news. Volatility in equity markets was at an all-time low over the 1990s bull market. Financial theory tells us that if volatility is lower, then the certainty of future returns increases, and markets should head higher as they discount this. But over the past three or four years volatility has started to rise.

Again based on financial theory, if the risk of an asset rises, the current price should fall, until the prospective future return increases to compensate for the new, lower, certainty of returns.

The level of volatility currently being experienced, and also currently being priced in options markets, is far higher than the level that has typically been observed in the past. If current equity markets reflect a level of expected volatility that eventually turns out to be too high then the effect on equity prices should be positive.

But the converse is also true – if volatility were to increase further, the rational response is for lower prices. Issuers should not expect institutional investors to respond with a knee-jerk reaction of shifting to higher equity weightings – pension funds can now probably meet their return (and risk) targets with a lower overall equity holding.

Current market conditions will have thrown up many issues for UK corporates and their finance directors. Not least are the shifting patterns of institutional demand, which will affect how companies will be able to meet their future funding needs.

There are some long-term grounds for investors to view the UK equity market as ‘good value’ (relative to certain other asset classes). This does not mean the market will not go down more in the next few months, and likewise it does not mean that markets will charge upwards. Similar analysis into other markets, particularly the US, may not produce such a flattering conclusion.

The risk of investing in equities has increased over the last four years, and (if the options market is to be believed) is expected to remain high.

These levels of volatility are high relative to history. UK corporates should also recognise the character of equities has changed. Yes, we expect a higher future return, but the price is higher expected future volatility.

  • Nick Horsfall is a senior investment consultant at Watson Wyatt.

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