Ever since the election, the equity markets have moved higher day after day. Merrill Lynch Global Research recently pointed out, for example, that the S&P 500 Index has gone 105 days now without a selloff of 1% or more. Take a look at the following chart of the S&P 500 Index. A very safe trading strategy has been to “buy the dip.” Investors who followed this simple strategy have made out nicely. The may have had to suffer for a few day, but within a week or two, the trade was in the black.
Investor willingness to buy on weakness has been one of a number of reasons why realized volatility and the VIX index are sitting at historically low levels. When prices fall, someone jumps in to halt a decline before it captures any momentum. Another reason is that while the indexes are showing “autocorrelation” (up days are following by more up days), the correlation between stocks is falling. We discussed this phenomenon, in a post called ” The Real Reason for the Collapse in Volatility which we posted on February 20, 2017.
The chart above shows the VIX for the NASDAQ Index, also know as the VIXN. As you can readily see, the implied volatility of the NASDAQ is at historical lows. Seems that US investors are so confident in the future of returns in the stock market that they do not want to do any hedging by purchasing puts or buying calls instead of owning stocks to limit risk. But it is not just US Investors. European investors are becoming complacent as well.
The above chart shows the VIX for EU stocks. One can plainly see that it is now touching historical low levels. These are levels not seen since the beginning of 2005. Does a suppressed VIV reading in the US and Europe portend, more upside? a risk of a smack down? We know that stock did pretty good in 2006 & 2007 and the VIX readings worked their way back up to more typical levels.
One of the issues that may tip the scales and answer this question is valuation. The following chart shows Shiller’s PE ratio. It compares the earnings of the previous 10 years to the current price of the stocks in the S&P 500. It is now at levels seen just before the famous stock market crash of 1929. The does not guarantee a crash, however. Earnings multiples went far higher in the dotcom / NASDAQ / tech bubble of the late 1990s.
So what does this tell us? Well, it tells us that even as confidence is high, investor complacency as reflected in historically low volatility and historically high valuation, suggests the markets could be in a fragile state. A piece of plastic can behave like it is strong and it can handle the load just before it snaps in two. We have been of the mind that we might see a messy correction of 5% or more sometime in the near future. This will be just enough to scare speculators into reducing leverage, which would prepare the market for another leg of higher prices.
We have recommended our readers place a beta hedge on their portfolio to protect themselves against the selloff we foresee. See our post entitled “A Time to Hedge” published on march 13, 2017. But we are starting to wonder if we are too soon in our forecast. The equity markets interpreted the Fed Statement as a bit dovish, even as they warned the market that 2 more rate increases are likely this year. If this Fed is behind the curve, then prices are likely to march higher as investors continue to act as if the Fed put is still in place.
Fortunately, volatility is low, making hedging with options cheap. So if the equity markets avoid a smackdown, you will not have to file a claim on your insurance. That is the good news because presumably your diversified portfolio will perform well in such a scenario. No one like to buy insurance, because you really do not want to collect on it. But you are happy that you have it, if and when you need it.
