Clients and friends of HFI Wealth Management will be dazzled by the presentation skills of the Hoxton advisor team tonight. Forcasts, Past & Present 2010.

What a week! While the US market was only open for four days, there was no shortage of interesting information to digest.

First, the election of Scott Brown in the Massachusetts Senate race served to illustrate that voters have become dissatisfied with something. Of course, it depends on which pundit you ask but the possible culprits could include healthcare, unemployment, the economy or the environment. Whatever the cause, it cannot be denied that the tenor of the administration’s populist rhetoric was stepped up after the election. The markets have historically voted against this sort of political talk by selling off.

Second, the President announced his intention of limiting the size of big banks and reducing the potential for systemic risk by banning proprietary trading operations, ownership of hedge funds or private equity operations, forcing banks to sell these assets at fire sale prices.  Even the President’s own Barney Frank argued against this rapid fire re-regulation of the banks. You can’t put the Glass Stegall genie back in the bottle so fast! Not surprisingly, the markets hated the President’s comments and sold off.

Third, international news is not good. There is growing evidence that Greece’s fiscal problems are spreading to other vulnerable European countries such as Spain and Portugal. Further, China, which recently  initiated a massive stimulus plan is talking about raising interest rates in an effort to slow its economy down. 

These news items helped send the S&P 500 index to a weekly loss of 3.9%. While we may be out of the heat of the financial crisis that engulfed us in the fall of 2008, last week’s action shows that risks remain and we always have to remain vigilant.

DO THE WILD SWINGS WE’VE SEEN IN THE MARKETS over the past couple years defy explanation? How is it that the S&P 500 index can drop 56% between October 9, 2007 and March 9, 2009 and then turn on a dime and rise 69% over the next 10 months, according to data from Yahoo! Finance? How can a company like Bank of America decline 94% and then rise 380% – all in less than the 30 months ending December 31, 2009? Or, how about Alcoa dropping 87% then more than tripling during the same period as Bank of America, according to The Wall Street Journal?

Aren’t the markets supposed to be “efficient” and “rational?”

These massive swings seem to happen with frightening frequency and investors who are unprepared for them will likely pay a heavy price. Benjamin Graham, arguably the “father” of security analysis and author of a classic book by the same name, said the price of a stock reflects two components. The first component, investment value, represents the discounted cash flow of all the company’s present and expected future earnings. The second component, speculative value, is driven by sentiment and emotions such as fear and greed.

It is not much of a stretch to suggest that an oscillation between investment value and speculative value may help explain the head-spinning volatility of the past few years. In other words, as markets rise or fall rapidly in short periods, speculative value may take prominence. Conversely, when markets are stable or moderately trending, investment value may take the lead.

Keeping this idea of investment value versus speculative value in mind can help us do a better job of maintaining a disciplined perspective on market volatility. It can help us better understand and potentially profit from the market’s periodic “inefficiency” and “irrationality.”