Mr. Sit: Two other comments that might be interesting. We have the New Horizons index of the valuations of large vs. small. At the end of September on forward earnings the New Horizons p/e ratio relative to the S&P 500 index is at a 17% discount to the S&P. Never in the 37-year history of this fund have we seen this level of undervaluation. I think that says an awful lot.
Number two is that on the 12-month basis the Russell 2000 growth index has lagged the Russell 1000 growth by 40 percentage points. Never in history has that happened before.
Mr. Holland: The spread between the Russell 1000 and the Russell 2000 is about 28% or 29%.
Mr. Sit: No, 40%.
Mr. Holland: It is actually 40% year to date.
Mr. Sit: Oh, You're right. I thought that was interesting.
Mr. Holland: It's unprecedented.
P&I: Alan, what insights can we draw from the volatility in the U.S. stock market this year? What lessons have we learned and what lessons should we have learned?
Mr. Bond: One of the things I have learned, of course, is to buy on weakness. But what I noticed is that the moves in the market are very sudden, both negative and positive, and I think that has a lot to do with the advent of technology, with the liquidity issues that we now have in the market, and the fact that the individual is much more active in the stock market in terms of trading strategies.
The corrections don't happen over six months. They might happen over six days. What we have seen in the last month or so is that the correction on the upside can be just as fast. It could be that because of the advent of technology, information is much more broadly available to everybody, and it is immediately factored into the marketplace.
Mr. Hansen: I guess my view on volatility is it's a little higher than average, but I wouldn't call it extreme. I guess looking forward my only concern is we can't increase the volatility levels much from here - it would be nice if they actually subsided a little bit - or I think we're going to begin to lose investors because even though returns look attractive, obviously, with higher volatility, higher risk, risk-adjusted returns of stocks don't look as high.
Mr. Sit: If you focus on the secular environment and the secular trends, there's a lesson, and that is there has been a lot of volatility. But if you cut through all of this and ask what is the underlying secular trend or what is the underlying secular environment, the answer, of course, is we are still in a deflationary or disinflationary environment. If you just focus on that and carry your decision forward, you would have done the right thing.
Mr. Holland: I agree with Loren. I think that while the volatility levels in fact did seem high, just based on the number of points that the market moves on a daily basis, we're actually pretty much in a long-term normal range for volatility levels. And I suspect that as we go forward when we get into what I perceive to be a 10% (return) world in stocks, which is what I think we're going to have over the next 10 years, I think that we'll get back to something more normal. The recent environment has been characterized by high turnover, momentum investing - that is, price momentum and earnings momentum. My guess is that will subside also as we get into a more normal world.
Mr. Paulsen: I would concur with Loren and Louis that volatility is high, but if you look to monthly and quarterly, you don't really get a lot of difference from history. So we're getting a lot of inter-day volatility.
I think that reflects the fact that this country is moving to a very important inflection point - we're going to zero inflation from the 50-year period of always positive inflation.
If you look back at the three bull markets in this century, the first one ended, I think, because we lost the price level in this country into deep deflation. The second bull ended because we lost the price level in this country into accelerating inflation.
As we sit here today, I think the volatility in the market reflects the battle of sentiment - we're at zero (inflation), and there is uncertainty now about which way will this bull end? Will it end like the '20s or will it end like the '60s? So on any given - almost - day, the morning may trade on the global abyss scenario that we're going to lose the price level into deep deflation and we're all out, and the afternoon may trade on the idea that it doesn't look like it's going to get that bad. And if it's not that bad, then the rate structure is down considerably, and this has got a lot of upside fuel.
P&I: Gene, who was driving the volatility? Was it individuals? Is it their proxies, the mutual funds and the hedge funds?
Mr. Sit: I would say what we saw was forced liquidation. What we saw in late August and September and part of October was started off with the liquidation relating to a Long-Term Capital Management, and then the spill-over effects to other hedge funds, and then the banks finally realizing that, hey, they are very extended in terms of loans to hedge funds. and that forced the Julian Robinsons and the like to liquidate, reduce their positions, and that affected the currency market and so on. The Fed saw the meltdown proliferating and they came in on Oct. 15, and that started the pages turning.
Mr. Paulsen: I think also that the buy-on-the-dip mentality has been so rewarded for so long that it has forced all managers of any ilk, they can't help themselves, to want to trade a little on this, because you can almost see it coming. When you start having stocks like Wal-Mart and Home Depot drop by a half and then go up by double within a matter of four or eight weeks or something, it just starts to make you play with your position sizes a little bit, so I think it adds to the volatility.
Mr. Bond: When you look back over the last five or six years, this summer was probably the closest we've been to a real crisis of confidence among the investors. Anyone who thought that the bubble was going to burst thought that this was it. I think this was the closest we had been in a long time towards a real meltdown in the financial system.
Mr. Hansen: Let me only add that I view that six-week to eight-week period as much scarier than my memory of 1987, especially in the fixed-income area, but also in the stock area.
I would also just add, on the individual investor, that I think they have been the salvation here. We've seen them stop putting money in during these declines, but they certainly have, as cash has built up, shown a propensity to come back in as things have quieted down. So I really think that it has been the professional managers that have done most of the momentum, move shifts, etc. that have hurt the markets at the inflection points.
