September’s rally was surprisingly strong, counteracting the normal negative seasonal bias. But investors should consider adopting a more defensive stance into the fall as the rally masked some troublesome deterioration in the economic environment.

Since 1896, September has had an average return of slightly worse than -1%, the only month of the year with a statistically significant bias. But this year September did not play to script. As of Friday, the S&P 500 closed up 2.4% for the month, Europe 2.7%, Brazil 3.7% and Hong Kong 7%. Three factors combined to contribute to the unusually strong month:

1. Massive new liquidity programs from the major central banks;
2. Market momentum; and
3. A lot of good luck.

In short, we got more than expected from both the Federal Reserve and the European Central Bank with their new asset purchase programs. And historically, September’s negative seasonal bias is much less pronounced in years when the market is up year-to-date, as is the case this year. Finally, much of the event risk that investors were worried about in Europe and the Middle East failed to materialize.

However, investors might be ignoring some troubling data on the economic front, particularly in the United States. One reason we’re a bit nervous about investor complacency is that along with the market rally, implied volatility collapsed in September. At the beginning of the month, the VIX Index–which measures implied volatility–was at 17.5, below its long-term average. As of last Friday, it was at around 15.

While the drop in volatility was partly justified by improving credit conditions, other factors that typically drive volatility have deteriorated. The Chicago Fed National Activity Index is now at its lowest level since mid-2009, which suggests much slower economic growth. In addition, we still have the looming risk of the fiscal cliff, which doesn’t appear to be currently reflected in equity prices.

Given this environment, we think investors should consider shifting some exposure from market cap weighted indices towards minimum volatility. Minimum volatility portfolios historically have produced better risk-adjusted returns over the long term while providing some downside cushion amid uncertainty in the near term. They’re worth considering if you’re worried about the recent slowdown and the potential for a pickup in volatility. Minimum volatility can be accessed through funds such as:

• iShares MSCI All Country World Minimum Volatility Index Fund (ACWV);
• iShares MSCI EAFE Minimum Volatility Index Fund (EFAV);
• iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV); and
• iShares MSCI USA Minimum Volatility Index Fund (USMV).

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. The Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.