The ongoing market volatility has sapped confidence and has many investors asking, “Is this another 2008?” and “Can I emotionally survive another downturn?” These are timely questions without easy answers. Equity volatility, by any measure, has increased dramatically since the beginning of August. One widely-followed measure is the Chicago Board Options Exchange Volatility Index (VIX ), which recently touched levels last seen during the 2008 credit crisis. However, most investors have their own ‘stomach acid’ indicator which, with 500 point swings during several trading sessions, has kicked into high gear. Trying to divine if the market (as measured by the S&P 500) is poised for another 51 percent drawdown is, as always, an unwinnable proposition. However, it is useful to be mindful of the fact that despite the challenges currently facing the economy, valuations for equities are much better today than when the market peaked in the fall of 2007.

• Dividend yields – The S&P 500 yields approximately 2.3 percent today vs. 1.80 percent at the market peak in October 2007. Today the S&P yields more than the 10-year Treasury bond (2.3 percent vs. 2.08 percent). Today’s yield is obviously a function of lower prices, but dividends-per-share for the S&P have actually increased since bottoming in the third quarter of 2009 after many financial companies that took TARP assistance reduced dividends to de minimus amounts.
• Earnings and balance sheets – Despite the disappointing pace of the economic recovery, operating earnings for the S&P 500 reached an all-time high at the end of the second quarter of 2011. This reflects efforts to make companies more efficient. As a result, aggregate corporate balance sheets are currently very healthy.
• Price/Earnings ratios – PE ratios are the most widely acknowledged way to value equities, because it represents how much investors are willing to pay for $1 worth of earnings. The S&P 500 was trading at approximately 19 times operating earnings at the 2007 peak vs. roughly 12.3 times today. The earnings yield of equities (inverse of the PE ratio) vs. what is available in the fixed income markets today is near the lowest-priced levels on record, another sign that valuations today reflect a more pessimistic view of the economy.

Attractive valuations, in and of themselves, certainly don’t provide a market immunity from decline. However, they can provide some degree of downside cushion. Stretched valuations, interest rates poised to increase or increasing, and future positive news factored into current prices usually make markets much more vulnerable. One could make a solid argument that, today, the opposite is true. Confidence is low, valuations are attractive and the Fed has indicated current policy (0 percent) will remain in place into 2013.

The cloudy economic outlook and recent declines are troubling, but equities had more than doubled from the March 2009 lows to the April 2011 highs and, as is historically often the case, were ripe for a correction. Today’s relatively attractive valuations and widespread concern about the economy argue that the market has already factored in below-trend economic growth in the second half of the year. It’s also important to note that the 17.6 percent decline in stocks from the recent peak actually decreases risk going forward, despite the emotional turmoil it has caused.

Bottom line, what is an investor to do? First, acknowledge that we are in a low interest rate, slower growth environment, which is often associated with lower investment returns for a period. Second, review one’s asset allocation to ensure it is still in line with risk and reward expectations. Third, in these more uncertain markets, maintain discipline relative to one’s asset allocation and, finally, embrace diversification as a risk management strategy.