Volatility Rises & Sectors Flip Flop

The past year was one of the more volatile in stock market history. In the entire history of the S&P 500, there have only been 11 days when 490 or more of the 500 stocks in the index all moved in the same direction on a given day. Six of those days occurred in 2011! That's a market that doesn't care one whit about the fundamentals of a company and is more focused on macroeconomic factors. The chart below, which shows the number of days the Advance/Decline line was more than 400, illustrates the wild swings in 2011.

It also shows how volatility has been increasing in the past decade. We've yet to have one of these turbulent days this year, but we expect the volatility of 2011 to continue -- for the simple reason that nothing has fundamentally changed.

We believe we are still in a secular bear market, one that is characterized by tremendous volatility in which rallies are to be rented and not owned. This chart shows just how dramatic the swings have been in the past two years.

The recent rebound occurred on the back of a 19.4% collapse earlier in the year. Our clients have been able to avoid this gut-wrenching ride thanks to our defensive positioning and focus on reducing correlation within portfolios.

The underlying problems remain. There has just been more kicking of the can and temporary window dressing. Most importantly, investors need to remember that many of the opportunities that arise during these turbulent times require the investor to disagree with the market. The best investments or strategies will periodically have several months of declines. This doesn't mean the strategy is wrong. It just means that it takes a while for the market to align with the underlying economic realities.

Don't believe the hype
Early in 2012, the seasonal and technical trends appear to have taken over from the fundamentals, and the market is rather desperate to get some nice rallies going. The strongest performers of 2011 are now the laggards in 2012. At Meritas, we don't believe for a minute that all is well, the angels are singing, Kim Kardashian's marriage to Kris Humphries has been saved, Superman is wearing Tim Tebow pajamas, and the Bachelor will finally find true love courtesy of "reality" TV. Well... the one about Superman probably was true until the Broncos' crushing defeat by the Patriots.

This chart shows returns by sector for 2011 vs. returns YTD in 2012 (through 1/13/12). Utilities and consumer staples, which led in 2011, are significant laggards so far this year. Financials and materials, the worst performers in 2011, are the two strongest so far this year.

Bottom line: We came into 2012 with the market rather overbought, and that trend has continued, and the market is in short-term rally mode. We believe that buying opportunities for the more defensive and income-producing sectors are likely to open up shortly. We believe these are the times when it is most important not to lose sight of the underlying economic realities and mistake market trends for economic predictions.