From Kelley Indianapolis' Glen A. Larsen, Professor of Finance
Equity 2012With publicly traded corporations delivering strong growth in 2011, why did equity markets lag in price appreciation during the same period? The short answer is that investors were selling stocks, even though the companies behind those stocks were making money. With the sell-off of 2008 fresh in everyone’s mind, investors were frightened into selling their shares of stock due to fears about a global sovereign debt crisis. After selling what they perceived to be risky equities in profitable companies, many then purchased what they perceived to be less risky securities such as Treasuries and portfolio insurance based on options. This can be referred to as a risk trade-off.
The good news is that we have recently seen the risk trade-off take a different turn. The CBOE Market Volatility Index, a specialized futures contract that is used to determine the settlement prices of options on the S&P 500, fell almost 20% in December 2011. The dollar volume of trading in this risk-management (portfolio insurance) tool has fallen 93% from its peak a few months ago. If the demand for portfolio insurance has dropped while the price of insurance has also dropped, it is a sign of improving confidence in equity markets. Said another way, traders seem to be moving away from trading risk and back to trading equity. More good news is that publicly traded companies continue to do well. The aggregate earnings of public companies hit a record high of $3.63 trillion in 2011 even though the S&P 500 Index still valued nearly 20% below its all-time high of 1,565.15 that was reached on October 9, 2007. While nothing is certain, the "good news" about a falling demand for portfolio insurance and rising corporate earnings could turn 2012 into a "good year" for investors in the equity markets.
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