Volatility you can believe in

11/10/2008


The major averages have bounced sharply from lows reached Oct. 27, retracing nearly one-third of the declines from highs reached in May and June. With the Dow Theory in the bearish camp and near-term trading likely to be volatile, subscribers should maintain cash at 25% to 35% of equity portfolios.

Upside potential
Market volatility has been incredibly high, and traders expect more of the same. Since the end of September, 18 of 26 trading days have seen gains or losses of at least 2% on the Dow. The CBOE Volatility Index, a measure of the future volatility implied by option prices, has retreated but remains well above historical norms.

Analysts are often quick to label such volatile trading as irrational, and it seems likely that panicked and forced selling contributed to the market’s sell-off. But blaming the market’s action on others’ foolishness is a time-tested way to get in trouble, especially when there are so many legitimate reasons for stocks to be volatile.

On the downside, investors are grappling with fears of an extended global downturn, uncertainty regarding the change in leadership in Washington, and a financial system on government life support. While predictions of another Great Depression seem like a stretch, expectations of an extended and nasty recession seem plausible.

On the upside, current valuations imply stocks have considerable room to rebound — if the worst-case scenarios of economists are avoided. As shown below, the median U.S. stock trades at 12.7 times trailing earnings, well below the norm of 17.4 since 1994. The median price/cash flow ratio is 8.2, versus the norm of 11.3 since 1994.

At 0.66, the median for current trailing P/E ratio divided by five-year average P/E ratio is the lowest in at least 14 years. All else equal, if this number returned to its 14-year norm of 1.01, the median U.S. stock would gain 53%.

Stock selections
All else is never equal, and the typical U.S. stock is not as cheap as backward-looking measures imply. But you don’t need to limit yourself to the typical U.S. stock. Instead, look for bargain-priced stocks supported by solid profit-growth outlooks. Harris ($38; NYSE: HRS) and Transocean ($85; NYSE: RIG) seem capable of meeting consensus expectations for solid year-ahead profit growth, and both stocks would more than double if they returned to five- or 10-year norms for P/E ratios.


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