Fear Is Good

08/18/2010 10:52 am EST

Focus: MARKETS

George Putnam

Editor, The Turnaround Letter

George Putnam III, editor of The Turnaround Letter, says the market’s new volatility has scared a lot of investors, but it may be a good buying opportunity.

It seems like we’ve seen two completely different stock markets so far in 2010. After a dip in late January, stocks could do no wrong through late April. At its high on April 26th, the Standard & Poor’s 500 index had risen about 9.4% from the beginning of the year.

Then, spurred by problems in Greece and elsewhere, the market changed direction dramatically. As a result, the S&P lost 15.5% from its April highs and now sits down 7.6% for the year.

Of course, “the market” doesn’t really do anything. Investors drive stock prices, and what we really saw was a sharp shift in investor attitudes. In March and April, many investors—some for the first time since before the melt-down in 2008—were looking to get more fully invested. Then, in May, they flipped, and they are now much more defensive.

A survey by the American Association of Individual Investors (AAII) found that in April investors had 60% of their portfolio in stocks, but in May that number dropped to 51%, the lowest level since July 2009.

One of the things that spooked investors in May was the return of volatility to the markets. The S&P 500 had daily moves of more than one percent on 70% of the trading days in May, the highest level since April 2009.

While we never like declining markets, we actually think that the recent volatility and investor concern may be a good thing. For the year or so prior to May, the markets had been so placid, and had been rising so steadily, that many people in the financial arena seemed to be ignoring risk again.

As some wise commentators have noted, it was as though investors had completely forgotten about the meltdown in late 2008, and were behaving the way they did in 2007 and before.  Perhaps the recent market action will remind investors that there is such a thing as risk and that they should pay attention to it.

As investors become more cognizant of risk once again, securities valuations should become more rational. In the turnaround and distressed securities area, it has been hard to find good values in recent months. As investors begin to price in risk again, that should change. 

Even though many investors are moving away from stocks, we strongly recommend against that. As we’ve frequently said, people who try to time the market usually get it wrong. This is confirmed by the AAII data. In March 2009 investors had the lowest percentage invested in stocks (41%) and the highest in cash (45%) in the history of the survey.

It was just at that point that they should have been heavily in stocks. March 2009 marked the beginning of one of the greatest surges in stock market history—the S&P rose 67% from its low on March 6th through the end of the year.

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