Toward Old-Normal or New-Normal?

11/07/2011 8:30 am EST

Focus: MARKETS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

In a sense, much investor education is flawed in that considerable attention is paid to stock analysis, with but little discussion of macro factors, observes Marc Gerstein of Forbes Low-Priced Stock Report.

I understand the reasons: We don’t want investors to get lulled into assuming they can predict the market—something few, if any of us can do reliably. But we can’t ignore the fact that big-picture factors collectively loom large in determining how individual stocks behave.

The present is a clear example of this. None of us are happy with what we’ve seen lately in terms of recent stock-price performance. If the pain is coming from factors we can control, we need to adjust our strategies. We start by examining comparisons between portfolio performance and market performance.

But that’s not all. It may be interesting to know that our low-priced stocks outperformed or underperformed the S&P 500, but smaller stocks have their own set of performance tendencies, and even when things look bad, we may still be picking among the best in the this area of the market.

That’s why I also look at the Russell 2000. But even this may be imperfect: Companies with low-priced stocks tend to be much smaller, and these issues receive much less institutional and analyst scrutiny than mainstream Russell 2000 issues. That’s why I’ve been experimenting with my own Low-Priced Stock Index.

We saw that much of the damage sustained by our stocks was based not on company-specific problems, but on their status as low-priced stocks, an area that’s been under extreme pressure lately with individuals (the main players in this area) often confused and intimidated, and staying on the sidelines. We also saw data indicating our selection protocol remains effective; that we are, indeed, picking from the best stocks in the low-priced area. That is what we can control.

So what will it take for investors to again take interest in the low-priced stock group? Nobody can supply a precise answer, but if there is one indicator you’d like to follow, I’ll suggest the CBOE S&P 500 Volatility Index (VIX).

Our first choice would be for it to return to its historically-normal 15 to 20 range. That would indicate a more normal degree of market stability.

But that may be too much to ask in this era of global interdependency, fast news, and algorithmic trading. We may have to face up to the possibility that we have entered a new paradigm in which the stock market will indefinitely remain more volatile than we’ve seen in the past.

But I think we can live with that, too, if we can see more consistency at the potential new higher level. (Volatility is not always bad; it works on both the upside and downside and as long as we’re doing a good job selecting the right low-priced stocks, that would be fine for us over the long run.)

What’s discouraging investors now, beyond the need to get accustomed to a new level of volatility (possibly a new-normal VIX range of 30 to 35) is the fact that the VIX itself has been so volatile lately. At such times, it feels as if nobody has a clue as to what’s going on, and many find it very hard to get interested in stocks when such conditions prevail.

Stabilization of the VX, even in the 30s, or near 40s, even if we don’t like it as much as when VIX was in the teens, would at least indicate that it’s OK again for people to develop opinions and form assumptions. That, I believe, is something to which we can look forward.

So I’m willing to stay the course pending a return to the old-normal, or the emergence of a new-normal.

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