Head-spinning volatility


Profit estimates for the year ahead continue to deteriorate, and economists seem increasingly convinced the U.S. is headed toward its worst recession in three decades. But many argue that stocks already reflect such expectations, that the panic selling of the last two months has gone too far.

While we agree that the sell-off has created some compelling bargains, we’re not convinced the broad market has bottomed. The market’s ability to hold above the closing lows reached Oct. 27 — 8,175.77 on the Dow Industrials and 3,364.98 on the Dow Transports — should be watched closely. Also worth watching are financials, as a breakdown to new lows in this sector would weigh heavily on sentiment. For now, keep 25% to 35% of equity portfolios in a money-market or short-term bond fund.

Supply and demand
The Dow Industrials declined in 16 of the first 21 trading days in October, and the average is headed toward one of its worst months ever. Yet the Industrials are roughly unchanged from three weeks ago, reflecting two single-day advances exceeding 10%. Until this month, the Industrials had staged only five daily advances exceeding 10%, with three of them in the 1930s.

Surveying the incredible volatility of the last two months, some have concluded that stocks are no longer trading on fundamentals, that looking for values is pointless when the stock market has become a casino. This is a dangerous line of thought, especially when it leads to complete disengagement from the stock market. Stock prices reflect the supply and demand for shares, and nothing guarantees these forces will always balance with stocks trading at “fair value.”

Moreover, considering all of today’s uncertainties, estimates of fair value vary widely. For example, the S&P 500 Index is quite cheap versus historical norms at roughly 10 times the 2009 consensus profit estimate of $94 per share. But very few investors believe 2009 earnings will be that high, and bears point out that earnings may not bottom until 2010 or 2011. If profits are headed toward an extended decline, today’s price/earnings ratios may be providing a misleading signal.

So, what’s an investor to do? First, don’t be surprised by a short-term rally. Based on sentiment and the percentage of NYSE stocks trading above 200-day moving averages, the market is oversold. Second, look for opportunities one stock at a time. Finding values among individual names is easier than determining the fair value of the S&P 500, especially when many stocks seem to discount worst-case scenarios. One hard-hit group with appeal is oilfield services and equipment, where top picks include National Oilwell Varco ($25; NYSE: NOV) and Transocean ($67; NYSE: RIG).

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