As the U.S. stock market hits new highs, and bond yields continue baffle everyone who “knew” that interest rates were bound to rise this year, the most dramatic data point of all might be volatility, which keeps plumbing remarkable lows. And this isn’t just stock-market volatility (as measured by the VIX index), the intermarket volatility index, which averages expected volatility of stocks, bonds, currencies, oil and gold is at its second lowest reading in 20 years.
What does this mean? Not sure–mixed signals.
One the one hand, low volatility means that prices aren’t moving much either way, which means that it’s difficult for traders to make money, which pretty much forces them to take more risk (usually via leverage) to amplify such meagre returns as can be found. And indeed, as I noted in my March 25th blog, NYSE margin debt has been hitting new highs.
All of which adds up to lots of risky behavior and a dearth of fear.
On the other hand, a low-vol, high-risk environment isn’t necessarily a harbinger of imminent doom. Although it’s not a healthy environment, historical precedents don’t indicate that a bear market must inevitably ensue.
One way the stock-market pressure may be alleviated is by rotating price declines among the various sectors comprising the total market. For example, small-cap stocks, which had a tremendous run last year, have languished in 2014 even as large-cap indexes like the S&P 500 have reached new peaks. And for the early months of the year, biotech stocks were red-hot, but have now dropped sharply. In addition, stock-market volume has been relatively low in recent days, averaging just 75% of normal volume, while only 10% of stocks in the S&P 500 have been hitting new highs even as the index itself does so (data from SentimenTrader). These are signs of weakness underneath the market’s apparent strength.
Despite the impressive array of pundits lined up to do so, no one can in fact tell you reliably what the markets will do over the next six months to a year. The research into such forecasts in unequivocal: if you want to know the direction of the stock market or of interest rates over the next six months or so, flip a coin—your 50/50 chance of being right is considerably better odds than you’ll get from relying on any pundit (and what’s particularly fascinating is that the more eminent the pundit, the less likely his or her forecast will prove correct!).
What we can say is that risk remains elevated in both the stock and the bond market. So you should check your personal risk-o-meter to decide whether or not your investment position and time horizon are such that you should just stay the course, or whether you should take some risk off the table because you can’t readily absorb a significant hit to your portfolio over the next year or two.