CWS Market Review – December 31, 2010

We have only today left in 2010! Before I get into the meat of today’s CWS Market Review, I want to wish everyone a happy, healthy and prosperous New Year. Our Buy List is about to close out its fourth-straight market-beating year, and I’m excited to continue our streak in 2011.

Today I want to discuss an issue that isn’t getting a lot of coverage in the financial media: the stunning drop in the stock market’s volatility . I can’t think of a previous period where the market has moved from such frenetic trading to such placid behavior in such a short period of time. If the financial crisis can be said to have a “denouement,” the last three months have been it.

Let’s look at some numbers. The average daily changes for this week so far have been (in order) +0.06%, +0.08%, +0.10% and -0.15%.

I apologize if those numbers just put you to sleep, but this is about as dull a market can get. Personally, I don’t mind dull. Lack of news is good news and the best news is that the market has been going up…albeit very, very slowly. Before Thursday’s pullback, the market had advanced for 17 out of 20 sessions.

Let me put some of this volatility in perspective. During the craziest period of the financial crisis, which is roughly the two months following the implosion of Lehman Brothers, the S&P 500 was rising or falling by more than 4% per day roughly half of the time. In other words, it was perfectly normal for the Dow to swing by more than 500 points on any given day.

The trading was so crazy that there were two separate 10% rallies just two weeks apart. A few days after that, there were four-straight sessions of changes by 6% or more. We hadn’t seen that kind of volatility in decades.

Slowly, however, the volatility began to fade. During 2009, the S&P 500 had an average daily swing of 1.7%. For this year thru October, the average daily swing was just 1.2%. There was a minor rise in volatility over the summer. To the Double Dip crowd, it was a clear warning sign that disaster was imminent. Fortunately, cooler heads prevailed and now we can see that it was merely a transient blip.

Despite how much volatility has fallen, it’s gotten even lower recently. Over the last 19 trading sessions, the average daily swing has been less than 0.3%. During that time, the market hasn’t gone up or down by more than 0.6%. So in the last four weeks, we haven’t had one single daily swing reach half of what the market was averaging for the year! Wow.

What does this lack of volatility mean for us? I think the role of volatility is overvalued in the stock market. Commentators often portray high volatility as bad and low volatility as good, but I don’t think it works that way. I view volatility as the perceived chance that a trend will continue, but it’s not a comment on what that trend is.

For example, a high volatility period may reflect growing disagreement among market participants that the economy will or won’t enter a Double Dip. As the infighting becomes more intense, volatility increases. Once market participants reach a broad consensus, volatility recedes. That’s what I think has been happening. Investors now broadly agree that the recession has passed and that we’re in a slow recovery with inflation well-contained. Volatility will rise again once a new narrative asserts itself.

The economic news continues to be hopeful. The latest report from the Chicago Purchasing Managers Index showed the highest reading since 1988. This index only covers folks in Indiana, Illinois and Michigan, but it’s usually a good bellwether for how the rest of the country is doing.

There are two economic reports coming next week that will tell us more about how the recovery is proceeding. First, on Monday, we’ll get a look at the ISM Index. I expect a reading between 55 and 57, perhaps higher.

Second, on Friday we’ll get the important jobs report. This is a toughie; I really don’t know what to expect. The jobs market continues to be dismal. We haven’t seen much positive data, though jobless claims just fell to a two-year low. I think Wall Street will be paying close attention. As I’ve said before, higher profit margins have been good, but we need to see top-line growth soon and that means we need to see more jobs.

Wall Street is definitely becoming more optimistic for next year. JPMorgan Chase recently raised its GDP growth forecast for 2011 from 3% to 3.5%. Goldman Sachs raised its forecast from 2.6% to 3.5%. The Federal Reserve now expects growth between 3% and 3.6%.

S&P currently expects the S&P 500 to earn $94.79 next year. Based on current prices, that translates to a forward P/E ratio of 13.3. Flip that over and you get an earnings yield of 7.5% which is more than twice the yield on the 10-year Treasury bond. The message is clear: Stocks are still the safe place to be.

Let me also remind you that the new Buy List goes into effect on Monday morning (you can see the new list at the website). For tracking purposes, I consider each yearly Buy List to be a separate universe, so I assume the Buy List begins afresh as a $1 million portfolio invested equally in the 20 different stocks. The gains or losses from the previous year don’t carry over though 15 of the stocks remain the same.

Once all the numbers are in, I’ll have a complete summary of how well the Buy List did in 2010. That’s all for now. I’ll have more market analysis for you in the next issue of CWS Market Review!

Best – Eddy

Posted by on December 31st, 2010 at 8:38 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.