When Volatility Is Good

05/20/2009 12:00 pm EST

Focus: MARKETS

Tim Middleton, editor of ETF Insider, says investors who fled from risk in 2008 are embracing it this year, and that's a healthy sign for the markets.

"Beta" is stock market jargon for volatility. The higher the percentage change over time in a stock's price, the higher its beta. iShares Russell 2000 Value Index (NYSEArca: IWN), which represents small-company stocks, has a beta relative to the Standard & Poor's 500 large-cap index of 1.2, meaning it is 20% more volatile.

Those two little words, "more volatile," mean small stocks go down a lot more than big ones in bear markets, but they also go up much more when the tide is rising. And beta is bouncing all over today's markets. In March, 71% of the trading days saw swings in the S&P 500 of more than 1%. The last time the market endured such a high percentage of extreme volatility was in 1933.

Obviously, investors' risk evaluation has changed. Emerging markets are vastly more risky than developed markets. Last year, investors were terrified of risk, and this year they are embracing it. Collectively, market participants have decided there is much less risk in 2009's market than there was in 2008's.

Of course, they could be wrong. We have no way of knowing today whether we are being carried upwards by a bear-market rally, or by a new bull market. What goes up can come down hard.

But the behavior of high-beta investments like those of emerging markets are one positive sign that this recovery is real. By "real" I don't mean we continue to go straight up from here. I mean that in the next downdraft we don't go significantly below the March 9th low.

But any such downdraft I would expect to be the last gasp of the bear. Looking ahead, signals are turning green. One of these is the Moving Balance Indicator, or MBI. It looks at market breadth, or behavior across the whole spectrum. It hit an historic low of 16 last Oct. 9, warning of danger ahead that was indeed terrible. On March 23rd, however, it hit 85, one of its highest levels in its 30-year history.

Another bullish sign is weakness in defensive categories like consumer staples. Consumer Staples Select Sector SPDR (NYSEArca: XLP) advanced only 4.3% in April, less than half the market's gain.

Yet another is cheap valuations, even after a two-month run up. According to research published by Leuthold Group, value stocks are as cheap now, relative to the overall market, as they were in 1984. Small-company stocks, which normally trade at a 10% to 14% premium price/earnings multiple to big-caps, traded in April at the same multiple, 11.2x this year's expected earnings.

Some sort of correction is all but inevitable, but I can feel a floor beneath them, and it feels solid. To paraphrase Gordon Gekko, risk is good. It is what draws us to investing, rather than saving. We've been punished by it long enough; it's time to be rewarded.

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