In his latest Market Update, Russ Koesterich, iShares Global Chief Investment Strategist, argues that current market expectations for volatility appear too low and investors should consider adopting a modestly more defensive stance…

Equity market volatility has been relatively low in the past six months. Since early 2008, the annualized volatility on the S&P 500 has been close to 30%, but in the last six months, it’s been a pleasantly dull 17% and stocks have benefited from another torrent of central bank liquidity. Whilst the VIX has risen in recent days, it has still tended to trade below its long term average of around 20.
 
Investors should avoid assuming this trend will continue. We expect volatility to rise and for stocks to experience choppier trading in the coming months.
 
When investors form expectations for future volatility, they take note of conditions in credit markets as well as expectations for near term economic growth. On both these counts, market expectations for volatility appear too low. Based on current credit conditions, and the past relationship between the VIX and leading economic indicators, we would expect the VIX to be trading in the mid 20s. In other words, volatility still looks around 25% too cheap.
 
The market is therefore vulnerable to a modest pull back. Historically for every 1% increase in market volatility, stocks have lost around 15 basis points. This implies that if, as was the case in early April, the VIX rises towards the low to mid 20s, this is likely to be accompanied by a 4-6% pull back in stocks.
 
While we’re not expecting a significant drop, to mitigate any losses we would advocate investors adopt a modestly more defensive stance. One possibility is to overweight more defensive sectors such as telecoms, which tend to be more resilient in a choppier market, and to include an emphasis on size and dividends.