In the short run, the stock market is a voting machine, said Benjamin Graham, considered by many the ultimate investing sage. But in the long run, it's a weighing machine, meaning that over time a company's shares will command the price its business prospects deserve, measured by such basic yardsticks as profit growth, balance-sheet strength and management vision.
SEE ALSO: Our Outlook for Bonds and Our Outlook for Stocks
For much of 2011, the stock market behaved like a gigantic voting booth. Traders (and investors behaving like traders) reacted to fast-changing economic and political developments by giving the market a categorical thumbs-up one day, an unqualified thumbs-down the next. So-called high-frequency traders, whose computer programs plumb minuscule price movements within nanoseconds and who now account for 50% to 75% of stock trading volume, have exacerbated the volatility.
The effects have been dizzying. In 2011 through November 4, Standard & Poor's 500-stock index saw intraday swings of 2% or more on 56 trading days -- 50 of them in the second half of the year. The index logged closing gains or losses of 2% or more on 29 days in 2011, compared with an average of five times a year dating back to 1950. And on a record 56 days, the number of S&P stocks advancing or the number of those declining exceeded 400 -- occurrences that Bespoke Investment Group dubs "all or nothing" days.
Rest assured that at some point the market will become a weighing machine again. Still, for much of 2012 we expect continued volatility and a seesaw market that will likely experience both breakout rallies and occasional downward spikes. We believe the economy will sidestep recession in 2012, muddling through with growth in gross domestic product of roughly 2% -- not enough to dent a stubborn, 9% unemployment rate. Inflation will moderate in 2012, falling back to about 2%, from more than 3% in 2011.
Corporate earnings will continue to rise in 2012, albeit at a slower pace than they have been since cratering during the 2007-09 recession. Figure on profits for companies in the S&P 500 to improve by 6% to 7% in 2012, a bit less than perennially optimistic Wall Street analysts expect. If the market maintains its current price-earnings ratio of about 12, the S&P index, which closed at 1253 on November 4, should appreciate by the same amount. Throw in dividends of about 2% and you'd earn a total return of 8% to 9%. (This analysis suggests that the Dow Jones industrial average, which closed at 11,983 on November 4, should pass 12,700 a year from now.)