Risks Grow Beneath the Surface of the Market

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Risks Grow Beneath the Surface of the Market

The question of the moment seems to be whether or not investors are feeling a bit too secure.

Is the market outwardly unconcerned – or largely unaware of actual dangers lurking beneath the surface?

Well, to begin answering that question, we can turn to the Chicago Board Options Exchange Volatility Index (VIX), which is somewhat mischaracterized as the market’s “fear gauge.”

A complacent market is often associated with a low VIX reading.

And, sure enough, the VIX recently dropped to the lowest level since March 2013.

Simply put, the S&P 500 has not been very volatile recently, and traders expect this tranquility to continue in the short term.

But this lack of stock market volatility – both historical (realized) and expected (implied) – is only one part of the story.

The sense of calm permeates the markets of other asset classes, as well . . .

When Déjà Vu Becomes Dangerous

The BofA Merrill Lynch Market Risk Index measures future price swings implied by options markets in global equities, interest rates, currencies and commodities.

As you can see from the red shading in the chart below, the financial markets haven’t been this complacent since May 2007.

When an indicator hits a level that’s only been seen once in the past 15 years, we should all take notice.

Especially when you consider that the S&P 500 reached a pre-credit crisis high in October 2007 – just five months after similarly low volatility expectations.

So what does that mean for us going forward?

A Fragile Market

It’s important to realize that a lack of volatility can be destabilizing.

In The Black Swan of Cairo, Nassim Taleb and Mark Blyth describe a dynamic that’s very applicable to our current situation:

“Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface.”

You see, while the S&P 500 is making fresh all-time highs, it’s being aided by a flood of liquidity (money) due to quantitative easing (QE). This liquidity has been competing to find investments, driving up financial asset prices.

And the last two significant spikes in volatility and implied volatility (circled in green on the chart above) occurred in 2010 and 2011 – during the absence of Federal Reserve stimulus.

So with the Fed currently tapering its QE program, it’s going to be very interesting to see how the markets respond once QE is completely halted.

I happen to think that the fragility of the market will be exposed and volatility will return with a vengeance, once again.

Of course, now it seems as though the market is expecting the European Central Bank (ECB) to come through with its own stimulus.

One has to wonder what would happen if central banks around the world simply let the “free” markets find equilibrium.

The longer we have to wait to find the answer – that is, the longer central planners attempt to suppress volatility and the business cycle – the greater the eventual carnage.

So don’t be lulled into a false sense of security.

Next week, I’ll talk about the implications of this complacency for our portfolios, and discuss a sector divergence that not only serves as a sign of underlying fragility, but should also guide our asset allocation and stock selection.

Safe (and high-yield) investing,

Alan Gula, CFA

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