More of the same... Don't count on it

12/15/2008


While investors tend to extrapolate recent trends well into the future, the stock market rarely behaves so predictably. Factors that characterize stock behavior in one year often don’t hold in the next. With that thought in mind, we examined three of the major issues affecting the market in 2008 and the outlook for 2009.

Volatility, volatility, volatility. 2008 saw nine of the 10 largest intraday point swings in the history of the Dow Jones Industrial Average, including a peak-to-trough swing of 1,018.77 points on Oct. 10, the largest ever. The Industrials declined 7% or more on four days in 2008, a record for one year. And there was plenty of upside volatility, including an 11% gain on Oct. 13.

Will such high volatility continue in 2009? Probably not, although volatility will likely remain above historical norms. But the crisis-a-day headlines and massive deleveraging on Main Street and Wall Street — factors that drove much of the volatility — should subside in 2009, especially in the second half of the year. That’s good news from an investing standpoint. High volatility breeds a trading mentality that is not conducive to sustained market advances.

The death of diversification. Conventional wisdom says diversification across and within asset classes is the best way to control portfolio risk. As the adage goes, “There’s always a bull market somewhere.” Thus, investors can improve their odds of having exposure to strong market sectors (while limiting exposure to weak areas) by spreading their bets. But in 2008, the only bull markets were cash and Treasury bonds. There was no place to hide in stocks. The table below shows year-to-date returns for various equity size and style categories. Note the tight correlation of negative returns.

FUND INDEX RETURNS
Stock-Fund Indexes *
YTD Return
(%)
Large-Cap Growth
(42.86)
Large-Cap Core
(38.63)
Large-Cap Value
(38.91)
Multi-Cap Growth
(44.59)
Multi-Cap Core
(41.67)
Multi-Cap Value
(40.00)
Mid-Cap Growth
(46.70)
Mid-Cap Core
(41.61)
Mid-Cap Value
(42.85)
Small-Cap Growth
(46.06)
Small-Cap Core
(40.01)
Small-Cap Value
(37.13)
Equity Income Fund
(37.33)

* Index returns, through Dec. 9, are based on the largest funds within the same investment objective and do not include multiple share classes of similar funds.

Source: Lipper

The obvious take-away from 2008 is that we have entered a new era in which all asset classes move in lock-step. However, news of diversification’s demise is a bit premature. 2008’s broad-based weakness stems in large part from massive deleveraging. Virtually all institutions — from hedge funds to banks to mutual funds — sold investments to reduce borrowings or satisfy investor redemptions. And that selling seems to have been proportional, with institutions dumping holdings across the board in fairly even chunks, regardless of asset class or quality. Such selling is rarely sustainable.

With a big part of the deleveraging likely behind us, look for institutions to become more discerning in both selling and buying next year. That should translate to greater separation in returns across asset classes. What style/size categories are most likely to lead the way in 2009? Growth stocks tend to have an advantage during periods of sluggish growth. However, nobody can truly predict who will win or lose coming out of this bear market. For that reason, diversification will be critical to portfolio risk and returns in 2009.

Value traps. This year has been particularly noteworthy for the number of blow-ups in financial stocks. While the Forecasts got out of many financials early and avoided much of the damage in the group, others weren’t so fortunate. In fact, a lot of “smart money” — hedge funds, prominent mutual funds, and private-equity groups — bought into financials at high prices. Many investors wonder whether financial stocks will remain value traps in 2009, and only time will provide an answer.

Based on most value metrics, financials appear cheap. And with the federal government seemingly willing to provide safe harbor for financials of all stripes, one could argue that perhaps these stocks have bottomed. However, investors indulged in similar “bottom-guessing” throughout 2008, only to see financial stocks keep plumbing new lows. Rather than guess at a bottom, the Forecasts prefers to utilize the power of our Quadrix® stock-rating model.

At this time, financials earn poor Quadrix scores, which gives us pause when considering the group. On the other hand, we see opportunity in energy, another beaten-down “value” sector. Quadrix scores for energy stocks remain strong. While the Forecasts underestimated the swiftness and severity of the decline in oil prices, energy stocks now trade at valuations that make them attractive over the next 12 months. Our favorites include Chevron ($76; NYSE: CVX), Exxon Mobil ($78; NYSE: XOM), National Oilwell Varco ($24; NYSE: NOV), Oceaneering International ($24; NYSE: OII), and Transocean ($54; NYSE: RIG).


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