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Could Today’s Market Leap Have Been Predicted?

Buoyed by strong gains in Europe, with investors hoping European leaders will come up with a plan to fix the region’s debt problems this weekend, the Dow finshed 267 points today. Could investors have seen it coming?

Some new research suggests yes. In a note to investors this week, Sam Stovall, chief equity strategist at Standard & Poor’s, offered a new method for gauging investors’ appetite for risk by comparing the performance of volatile stocks with less jittery ones. The strategy, he says, could provide clues to the market’s next move.

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Historically, analysts trying to determine whether the stock market is in “risk-on” or “risk-off” mode might have compared the performance of two baskets of shares.  In the first basket are companies whose goods stay in stable demand whether the economy soars or swoons, such as medicine and electric power.  In the second basket are companies whose goods sell well when consumers are flush, like restaurants.  If investors are seeking refuge in consumer staple shares, the thinking goes, they’re shedding risk, and the broad market may be due for a dip.  If they’re loading up on consumer “discretionary” names, they’re feeling optimistic, and stocks might broadly rise.

But investing pros and analysts say that gauge may no longer work: The divide has blurred between things consumers need and the things they merely want.  “The whole notion of what’s defensive and what’s economically sensitive has changed a lot,” says Peter Tuz, president of Chase Investment Counsel, an investment management firm based in Charlottesville, Va. “It’s just not as clear cut as it used to be.”

Take McDonald’s, says Tuz: It’s a restaurant, so traditional thinking holds that its sales should suffer during recessions.  But the company’s sales held up well during the most recent recession, he notes, perhaps because some consumers now view McDonald’s as a cheap supplier of meals — not an occasional treat.  Similarly, some telecommunication companies don’t fit neatly into either category: Internet has become less of a luxury and more of a necessity for work and low-cost entertainment, says Tuz.

In a recent note to investors, Sam Stovall, chief equity strategist at Standard & Poor’s, offered another way of gauging investors’ appetite for risk, which involves comparing the performance of two different baskets of stocks: one with high past trading volatility (“high-beta”) and one with low volatility. Investors would only seek out volatile shares if they expect stocks to broadly rise, he notes, so when those stocks outperform their less volatile brethren, it’s a bullish sign.

The relationship between stock returns and demand for volatility has been strong, says Stovall. An investor who put $1,000 into the Standard & Poor’s 500-stock index at the end of 1999 made $833, not including dividends, by Oct. 14, according to Mr. Stovall.  Investors who bet on the index only during months when consumer discretionary stocks outperformed consumer staples would have turned $1,000 into $5,630, he says.  But one who held the index only during months when high-beta stocks beat low-volatility ones turned it into $8,211.

Of course, Stovall points out that those numbers assume an investor had the foresight to hold shares during just the right months, which is unlikely. Studies have shown that investors typically pick the wrong times to buy and sell stocks.  But nervous stock investors looking for more clues on when to buy and sell might want to compare the performance of volatile shares with dull ones, he says.

For regular investors, one strategy is to track the performance of two exchange-traded funds, say analysts: the Powershares S&P 500 High Beta portfolio (SPHB) and its low-volatility counterpart (SPLV).  When the former begins pulling ahead, it could be an early indicator that stock investors are feeling bolder.

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