A Wall Street investment chief lays out a foolproof formula for 'spectacular' stock gains - and says Fed actions could soon offer the perfect setup

Bryan R Smith
Volatility is often seen as a threat to investors, since it is usually associated with falling stock markets.

Jim Paulsen, of The Leuthold Group, said that volatility has become an investor's best friend over the past decade of Federal Reserve's practice of quantitative easing.

Here are some ways investors can profit from a possible future scenario where volatility pays off.

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Volatility is a frightening word on Wall Street because it can bring back painful memories for investors who have experienced rapid and severe price drops in the stock markets.

Investors have been scared by volatility since the 1987 crash and the burst of the dotcom bubble. They are now ready to flee the country in panic.

Jim Paulsen of the Leuthold Group is the chief investment strategist. He believes that market volatility can make an investor's life easier, since forward returns have been historically strong for stocks.

Paulsen outlined the conditions in which investors should be bullish on stocks despite rising volatility in a recent client note. This is largely due to the Federal Reserve's ongoing quantitative ease policies.

Paulsen stated that investors should be aware of how the Fed has changed the investment landscape and be ready to exploit 'valuable volatile' when it is available. QE is a constant and massive use that has effectively squashed volatility in the bond markets, creating more opportunities for stock investors who are looking to capitalize on a particular 'valuable volatility.

According to the note, Paulsen's profitable stock setup is based on equity volatility rising and bond volatility remaining low. Since the Fed started quantitative easing measures, bond volatilty has been below 97% on average. Prior to quantitative easing bond volatility was only 31% below average.

According to the note, volatility spikes in stocks, but stays subdued in bonds, which means that market performance is more than twice as good on a 1-month, 3-month, and 6-month forward timeframe.

Stock investors have a great opportunity to profit from the combination of a high level of concern for stocks and the perception of stability in bond markets. This is a volatility' that's worth investing in, at least since 1990. said Paulsen. This scenario is more common because of recent Fed actions.

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Prior to 2012, there was only 8.8% frequency of below-average stock volatility and above-average bond volatility. The note stated that the Fed had "provided the stock market this gift almost 20% of all the time" after 2012.

Paulsen stated that the quantitative easing policies have likely contributed to both volatility and the risk of bond volatility. Paulsen claimed that the easy money policies had helped to depress bond volatility, but also created a wall of concern among stock investors because of the potential ills associated with overuse and misuse of monetary policy.

Paulsen stated that bond volatility is still low and the VIX only two points below its average. This could mean that a period of valuable volatility is just around the corner. The VIX index "will likely eventually slip above average and provide equity investors with an additional opportunity to enjoy Valuable Volatility!"

Paulsen measures volatility of stocks using the VIX Index, and volatility of bonds using the MOVE Index.

The Leuthold Group