Who Slipped Investors a Chill Pill?

Who Slipped Investors a Chill Pill?


Can anything halt the seeming inexorable upward climb of the U.S. stock market?

Valuation concerns have caused a few hiccups along the way, to be sure. Earlier this month, a string of new record closes in the S&P 500 index ended when investors took fright at the absolute numbers, the price/earnings ratio ($16.50 for every dollar of estimated profits at the 500 companies this year) and the fact that some technical indicators were beginning to sound alarm bells.

But since the last big market decline in 2011 — when the S&P 500 plunged 19 percent between April and October amidst widespread fear that a meltdown in Europe’s peripheral economies would spread throughout the region — U.S. stocks have shrugged off pretty much everything that the world has hurled at them.

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The Federal Reserve is backing away from its support for the bond market and thus, for ultra-low interest rates and the economy? OK, so be it. A really bad winter causes the IMF to slash economic growth forecasts and companies to report a flurry of disappointing earnings? Meh. Civil war in Syria, brinksmanship in Ukraine, and a sudden eruption of intense violence in Iraq? At best, a one- or two-day interruption in the festive atmosphere.

Indeed, we have managed to go for nearly 32 months without seeing the S&P 500 index correct by 10 percent or more. As Sam Stovall, a strategist at S&P Capital IQ, has pointed out, that’s worrying: The average interval between such declines is about 18 months. By any standard, we’re overdue, and Stovall himself began suggesting back in April that we’d see a 10 percent to 20 percent correction sometime in the second quarter.

We did begin that month with a worrying selloff, but one that was largely confined to the most speculative technology and biotechnology stocks, which had witnessed the most explosive gains. Aside from a few days here and there when the negative sentiment leaked into the broader market, the problems never halted the overall forward march of U.S. stocks as an asset class. And now we have less than two weeks left in the month for Stovall’s prediction to come true.

The calm seems almost eerie, as if market participants have had their supplies of gourmet bottled water spiked with Xanax or Ativan. Just look at some of the data points: the “Fear Index,” or Chicago Board Options Exchange Volatility Index (VIX) has been in freefall all year and now hovers near its lowest level since 2007.

Trading volumes also are low, and falling, signaling to some pros that investors have been lulled into a sense of security by the rising market and are quite happy to sit on the sidelines and let it keep rising, not feeling the need to tweak their positions. Hedge funds are quite willing to bet that this state of affairs will continue.

The market’s biggest fear, it seems, is a lack of fear.

Bucking the status quo — challenging an established trend — is never a great idea for traders like those in the hedge fund arena. But that doesn’t mean that investors should sit calmly by in the expectation that markets will continue to shrug off any bit of bad news that is thrown their way.

Consider, for a moment, the fact that the last time the VIX was as low as it is today, it was on the eve of a particularly bloody episode in financial markets history: the subprime real estate market collapse, followed by the near-collapse of the entire financial system.

Granted, we’re not likely to witness a repeat of that scenario. But back in early 2007, how many pundits were standing up publicly to warn investors that Armageddon was looming on the horizon? Yes, some spotted the stresses and strains, but they weren’t broadcasting them to all and sundry. Odds are that there is something in the market today that at least has the potential to destabilize the stock market, even if it doesn’t rock it to its foundations in the way that the subprime lending crisis of 2007 did.

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Anyone who stops to think for a few minutes can come up with a few reasons to worry. Geopolitical factors spring immediately to mind. We simply don’t know yet how great the problems in Iraq will be, but compared to the situation back in 2002 and 2003, our ability to contain them and to work with allies are laughably limited. Nations that once stood by are now at best quietly hostile — as is Russia, in Ukraine.

That conflict, and the Syrian civil war, have shown that our ability to handle geopolitical crises is nowhere near what it has been or should be, relative to the size and “hard power” of the U.S. military. If anything, the risk is that the outbreak in Iraq will simply encourage other outbreaks, further destabilizing the global economy and making economic growth and corporate profitability far more uncertain. Sure, that’s just one scenario — but it’s a plausible one.

Then there is the structure of the market itself. The Senate Investigations subcommittee held a hearing Tuesday into the question of high-frequency trading, sparked in large part by the publication of Michael Lewis’s Flash Boys. I’ve got reservations about the book being used as the basis for market reform proposals — small errors and misunderstandings of the nature of market structure add up to present an incomplete picture of the topic — but the issue itself merits serious scrutiny, if only because many of the reforms proposed haven’t yet been tested.

A sudden selloff in bonds could cause investors to freak out; so, too, could bad news on the earnings front.

Don’t draw too much comfort from the calm, either. Remember that the VIX isn’t a terribly good forward-looking indicator. The VIX measures what’s happening to options prices, which tend to rise when investors want to buy them to cover their butts. The higher the volatility, the higher the price of the options — and the index. If those options aren’t in demand, the VIX languishes.

Smugness and complacency is one explanation for the current low levels for the VIX; another is that the usual suspects simply don’t want to cough up for the protection. If that’s the case, then any downside move, once it comes, may actually end up being even more violent, since it won’t be cushioned by these hedges.

In other words, enjoy the calm for now if you want but don’t let it lull you into a lackadaisical mindset.

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