Jeff Benjamin

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Something to fear: fear itself

Low “fear index” reading a symptom of the top of a market cycle

Jul 11, 2014 @ 10:02 am

By Jeff Benjamin

In the world of financial market push-me-pull-you, there is nothing quite like the counterintuitive reality of market volatility, which is currently lower than it has been in years.

Commonly dubbed the “fear index”, the Chicago Board Options Exchange Volatility Index (VIX) is languishing near its lowest point since 2007.

If fear, as measured by volatility, is low, that's a good thing, right?

Sort of.

Nobody wants to be reminded of what followed the 2007 volatility trough, but it sounds a lot like “financial crisis.”

That doesn't necessarily mean the markets are headed down the same path this time around, but it does say a lot about investor complacency and valuation levels across virtually every asset class.

“Investors' senses should be heightened when volatility is low, because, like the weather, if you stick around long enough it will change,” said Mark Travis, president of Intrepid Capital Funds.

For perspective, consider that the VIX is currently illustrating an implied volatility level of just above 12 after falling to nearly 10 during the first week of July. This compares to a historical average level of 20.

In round numbers, a VIX level of 16 represents a 1% daily stock market fluctuation, up or down, in the next 30 days. And it has been more than 60 days since the stock market has moved more than 1% in a single trading day.

Across the financial markets, low volatility will mean different things to different people. Traders, for instance, generally need market activity in order to prosper, and they dread periods of low volatility.


Most market watchers, meanwhile, will usually acknowledge that extremely low volatility is at least a symptom of the top of a market cycle.

But for much of the retail investor class, low volatility feels great because the markets appear calm, if not upwardly positive, which leads to more investing by this group at some of the worst possible times.

It is true that there have been periods where the VIX lingered in below-average ranges for years, including the late 1990s and much of the 1950s and 1960s.

But it is important to keep in mind that the volatility level is less about a single market indicator than it is a reminder or forewarning of where we are in a particular market cycle, and should be examined in the context of that market environment.

The S&P 500, which has historically corrected by at least 10% about every 18 months, has not experienced a pullback of 10% or more in 32 months.

The benchmark's 12-month return, which historically averages in the low double digits, is at 25%. The five-year annualized performance is a startling 20%.

The average cash levels held by mutual fund managers is at an unusually low 3%. And margin debt levels across brokerage platforms has reached $408 billion, surpassing the peak levels of bubble periods in 2000 and 2007.

A lot of people have blamed these valuation extremes on the Federal Reserve's quantitative-easing program, which amassed a $5 trillion balance sheet and continues to hold interest rates at historic lows.


But the idea that traditional debt holders — and anyone else seeking any kind of yield — have been forced into the riskier equity markets is no longer even being debated. It has become accepted as the way it is, and that's OK until we get to the point where rates start rising and the Fed starts reducing its record-level balance sheet.

“The aggressively accommodative stances from the central bankers have had a big impact on depressing market volatility, but what's a little unprecedented is that it has become global in nature,” said Zoe Brunson, director of investment strategies at AssetMark Inc.

According to Jeff Kilburg, founder and chief executive of KKM Financial, the month of July has historically seen a 9% average spike in the VIX.

“Volatility has been suppressed by central bankers, and there's no precedent here for the Fed's activity,” he said. “People are pretty optimistic, and that's what has crept into the markets.”


Even those folks suggesting the current volatility levels are not a major concern are having a hard time making the numbers add up.

“Wall Street is singing the blues because there's no up-and-down volatility, but we think it's a great time to invest even it if isn't a great time to trade,” said Jim Russell, senior equity strategist at U.S. Bank Wealth Management.

He added that he expects the S&P 500 to reach his 2014 target of 2,030 by the end of September.

The fact that the index only needs to gain about 3% from where it is currently trading to reach that mark, and the fact that there still will be at least three months left in the year once the 2014 target is met leads Mr. Russell to acknowledge even his own analysis would call the market technically fully valued.

“Increasingly, a lot of things don't look cheap,” he said. “And stocks are approaching fair value.”

There's a good chance that is a big understatement.


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