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2006-12-17 :: 2007, a Stock Pickers Market

The chart above prepared by Harry Shiller compares the return of the S&P 500 to the Volatility Index. The index is a classic technical indicator showing the implied risk in the market derived from the trading of put and call options. The lower the reading on the VIX the more implied risk in the market.

As you look at this chart you can see the notation that the VIX is at a 10 year low and the S&P is at a multi-year high. This is a good indicator that we’ve had a liquidity driven push up of the mega-cap stocks in the S&P 500. The institutional investors that were sitting on the sidelines have put there cash to work in the index, driving it higher, without regard to valuation or fundamentals.

For those folks that are anticipating that 2007 will a repeat of 2006, and that index-style investing will once again beat fundamental analysis and stock picking, I believe they are in for a sad time. The last time the VIX was at this level, in 1993 (according to Harry Shiller’s analysis) we had the S&P returning 2% in the subsequent year as valuations caught up with earnings. The VIX being at this level does not necessarily mean that we are in for a bear market. All it really means is that the liquidity driving the market higher is likely already in the market and won’t be available as a catalyst any longer.

So, look for 2007 to be a return to earnings and valuation based performance in equity investments. Picking the right stocks in the right industries will once again provide the returns we all expect from equity investments.

More later!