Volatility: Too Low for Too Long?

S&P says investors should rebalance, not retreat

Financial markets are driven by what John Maynard Keynes called "animal spirits," the most powerful being fear and greed. One widely tracked gauge of fear is the CBOE Volatility Index, or VIX, which measures the market's expectations for near-term volatility as conveyed by S&P 500 index option prices. Higher readings point to increased investor anxiety.

Currently, the VIX is trading at multi-year lows, suggesting that fear is in deep hibernation. But when combined with the strength in global markets over the past three years -- the S&P Global 1200 is up roughly 100% since March 2003 -- many market participants are concerned that the complacency implied by the VIX is spreading, leaving global stock markets vulnerable to attack by the dreaded bear.

Not likely, in the opinion of S&P Equity Strategy. We believe the reason for the complacency is less the sloth of bulls than the fact that equity fundamentals are, in a word, excellent. Liquidity is ample and inflation is low, both of which serve to depress interest rates and fuel unprecedented global M&A activity. At the same time, attractive 2007 growth prospects and low p-e-to-growth ratios are lending important valuation support to global stock markets.

In this climate, investors concerned about a spike in volatility should watch for any deterioration of these fundamentals. We do not believe, however, that such an erosion is nigh. Modest portfolio rebalancing is certainly appropriate in light of recent gains. But given the difficulty of successfully timing the market -- requiring both a graceful exit at the top as well as a cool reentry at the bottom -- S&P Equity Strategy does not currently advise significantly reducing equity exposure.

Global equity valuations are historically low, especially given healthy 2007 earnings expectations. Despite a consensus 2007 earnings growth projection of 9%, above the historical average, the S&P Global 1200 index is currently trading at a p-e of only 14.6, a 12% discount to its long-term average of 16.5.

We believe conservative valuations reflect fears of a U.S. economic recession, led by a collapse of the housing sector, and the potential negative impact on global growth and corporate profits. However, increasing domestic demand in Europe, Japan, and key emerging markets (which now account for 50% of global GDP growth) is creating a macroeconomic landscape wherein the world is less dependent on exports to the U.S. to maintain a healthy expansion. In addition, fears of a U.S. slowdown have been widely telegraphed and are now fully discounted, we believe, in valuations, both domestically and internationally. As a result, we believe consensus 2007 global GDP and profit growth estimates are achievable and should enable continued strong equity performance.

In addition, low global interest rates are supporting equity valuations by lowering both the cost of capital and the appeal of competing asset classes like fixed-income. We believe this will continue in 2007, thanks to abundant liquidity stemming from benign global inflation, historically low corporate default rates, record Chinese foreign exchange reserves, and a growing cache of petrodollars.

In conclusion, S&P recommends staying with a 60% equity allocation that dedicates 40% to U.S. stocks. Specifically, we advise 34% in large-cap, 4% in mid-cap, and 2% in small-cap issues. In addition, we advise a 20% international equity allocation, with 15% in developed markets and 5% in emerging markets.

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