A Year After Meltdown's End, a Changed Stock Market

More has changed for investors in the past year than the value of their portfolios.

By several measures, today's conditions in financial markets look quite different from those on Mar. 9, 2009, when the stock market finally stopped a 17-month slide that erased more than half the value of the broad Standard & Poor's 500-stock index.

"People forget how bleak it was at that time," says Martha K. Pomerantz, investment principal at Lowry Hill Investment Advisors. The S&P 500 dived 57% from October 2007 to last March. "Very few people were really brave enough to put money back to work at that point," she says.

Since Mar. 9 of last year, the S&P 500 has rocketed back 66%. (The index still remains 28.3% below its all-time high of 1565.15 reached Oct. 9, 2007.)

While prices have recovered, the effects of the market's roller-coaster ride have been profound. Other market indicators also demonstrate how much equity conditions have changed over the past year. The new environment is evident in stock volatility, investment sentiment, and the relative performance of different types of stocks.

1. Volatility

The Chicago Board Options Exchange SPX Volatility index, or VIX, measures the implied volatility of the S&P 500—how violently it moves from day to day or minute to minute.

The VIX averaged 13.7 in the tranquil years from 2004 through 2006, but the index hit a record 80.9 on Nov. 20, 2008, and remained above 40 last March. Since then, "it's just really been a steady creep down," MF Global (MF) Vice-President Todd Colvin says. One calming influence has been aggressive actions by the Federal Reserve and U.S. Treasury, which Colvin calls a "government-induced safety net."

The VIX closed Mar. 4 at 18.8.

A year ago, stocks bounced up and down wildly on each day's headlines. Recently, headlines about fiscal problems in Europe or weak U.S. economic data haven't had the same effect, says Robert W. Baird's chief investment strategist, Bruce Bittles. "The market has been able to absorb a lot of bad news," he says.

2. U.S. vs. International

A year ago, economists assumed the U.S. would be hobbled by economic and financial problems, making the rest of the world more fertile ground for investments. Now, "relative to international markets, the U.S. is looking more favorable," says Dave Hinnenkamp, chief executive of KDV Wealth Management.

In 2009, U.S. stocks lagged the rest of the world. The MSCI EAFE index, a measure of developed country stocks outside the U.S. and Canada, rose 27.8% last year, and the MSCI Emerging Markets index jumped 74.5%. The S&P 500 rose 23.45% in 2009.

So far in 2010, however, the S&P 500 is up 0.7%, while the other two indexes have lost ground. The MSCI EAFE is off 2.7%, and the MSCI Emerging Markets index is down 2.3%.

Part of this has to do with a stronger U.S. dollar, Hinnenkamp notes, while a credit crisis in Greece has also rattled European markets.

Hinnenkamp and Pomerantz still recommend a healthy international allocation for long-term investors—especially for Asia, where growth prospects are higher and the debt load is lower than in the U.S. or Europe.

3. Growth vs. Value

Investors often split stocks into two categories: Growth stocks are faster growing and more sensitive to the economy, and value stocks are slower growing but more stable and consistent. Value stocks often pay a dividend, while growth companies often reinvest profits in further growth.

In 2009, growth stocks had double the advance of value stocks as investors began to believe the economy was picking up. The Russell 1000 Value index rose 16.3% in 2009, while the Russell 1000 Growth index jumped 34.8%.

So far this year, growth and value are on equal footing. The growth index is up just 0.5% since the beginning of 2010, while the value index has risen 1.5%.

Harder to quantify is a shift toward higher-quality stocks—those with less debt and more cash—and away from the lower-quality stocks that saw large gains after the Mar. 9 low.

Last year, "the [low-quality stocks] that had been trashed the most came back the hardest and fastest," says John Merrill, chief investment officer at Tanglewood Wealth Management. Since then, investing dollars "began to rotate into high-quality assets."

Michael Church, chief executive of Addison Capital Group, notes that prospects for financially strong companies remain bright. "Some of these large-cap international firms are better on a credit basis than many governments," he says.

4. Sector Leadership

Fashions on Wall Street can change quickly, with investors favoring energy stocks one month and financial shares the next.

In 2009, the winner was the technology sector. The S&P 500 Information Technology index was up 59.9% in 2009, 36.5 percentage points better than the S&P 500 overall and 14.7 points better than the next best sector, materials.

In 2010, the clear leader has been industrial stocks. The S&P 500 Industrial Index has gained 5.2% year-to-date, followed by the S&P 500 Consumer Discretionary Index, up 4.5%.

Despite all that has changed, investors' opinion of one sector has remained consistent: The S&P 500 Telecommunication Services index, which includes AT&T (T) and Verizon (VZ), lagged all other sectors in 2009, when it rose just 2.6%. It's also in last place in 2010, down 10% since New Year's.

5. Sentiment

Of all measures of market conditions, investors' moods may have changed the least.

One way to gauge individual investor sentiment is to watch how much money is flowing into or out of stock mutual funds. According to TrimTabs Investment Research, $6.2 billion did move into equity mutual funds in January. That was the first positive inflow, however, since July. (In all of 2009, $31.8 billion flowed out of equity mutual funds.) In February, investors pulled an estimated $7.8 billion out of mutual funds again.

Investors still bear the psychological scars from the past couple years, Hinnenkamp says. "I don't know that people's psyches have moved as far along as the markets and economy have."

The caution and wariness can still be seen in investors who buy safe government and corporate bonds despite extremely low interest rates, says Bill Larkin, fixed-income portfolio manager at Cabot Money Management. On Mar. 4, the yield on a two-year Treasury note was just 0.85%. "A lot of people are still nervous," Larkin says.

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