Over the last six months, the 100 least volatile stocks in the S&P 500 have beaten the S&P by a whopping 6.6%. According to Jim Paulsen, the Leuthold Group’s chief market strategist, this represents one of the best six-month periods for low-vol stocks since 1989.

But like so many other market agents, these stocks have behaved in ways that have taken on a different meaning during the current economic expansion. “Their periodic popularity no longer reflects a simple desire to lessen cyclicality,” Paulsen writes in a note to clients.

Before 2007, low volatility investing was seen as a “defensive hedge against anticipated economic weakness in economic conditions,” Paulsen says. Today, the outperformance of widows-and-orphans’ stocks signals “excessive” investor fear and pessimism. That implies a much better environment for the overall stock market than it did in the pre-2007 era.

It’s true that in recent months investors have been buying bonds for capital appreciation as much as income, while also adding gold to their portfolios. In this expansion, however, low-vol equities have joined these other vehicles as a “fear indicator,” Paulsen says.

Nowhere is this more evident than in the changing relationship between the bond market and low-volatility stocks. Between 1991 and 2007, the “correlation between the daily Low Volatility relative total return index and the 10-year Treasury bond yield was only -0.27,” Paulsen says. That means it was “loose at best.”

Since 2007, however, the correlation has “surged to -0.73, aligning the return character” of low-vol stocks in a remarkable resemblance to the bond market, he continues. Viewed another way, Granny’s stocks have gone from being bond-sensitive to “bond surrogates.”

How long can the trend remain investors’ friend? Paulsen suggests that after a six-month period of stellar top-quintile returns like those of the past six months, the outperformance of low-vol stocks is likely to continue for the next half year—to a relative outperformance of 6.58% going forward. Furthermore, the chance of underperformance “in the coming six months was less than 30%.”

The implications for the broader market are complex. Since 1989, the S&P 500 has averaged -0.75% after any six-month period in which the 100 least volatile stocks have outshone the pack.

Since 2007, however, that has reversed completely. In fact, after periods like the last six months when low-vol stocks have been in the top quintile, the S&P 500 has "provided a +8.63% average six-month forward total return," Paulsen says. And it has generated a negative six-month forward return only 13.1% of the time.

What are the implications? For those who don't want a scorecard to keep track of Paulsen's intricate methodlogy, it means the S&P 500 should beat the S&P's 100 least volatile stocks over the next six months. If one looks at how well PepsiCo, Coca-Cola and many utility and REIT shares have done in the last six months, that shouldn't be a big stretch of the imagination.

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