Neither Fear nor Favor

June 5th, 2014
in contributors

Investing Daily Article of the Week

by Philip Springer, Investing Daily

Many investors continue to sit out this bull market, but the participants don’t seem overly worried. Contrary to expectations, investors have piled into bonds of all kinds this year, sending prices to their 52-week highs and yields to yearly lows last week when the 10-year US Treasury fell to a miserly 2.45 percent yield.

Follow up:

The Standard & Poor’s 500 reached its 13th all-time peak of 2014 yesterday, closing at 1920. After slumping in January, recovering in February and mostly trading sideways since then, the benchmark index is up 3.9 percent for the first five months of the year.

Since 1960, there have been nine years in which the S&P 500 rose by less than 4 percent through May. In seven of those nine instances, stocks kept rallying through the end of those years.

Yet buying enthusiasm for stocks remains muted: Trading volume on the New York Stock Exchange totaled some 2.7 billion shares yesterday. That was above the low for the year that occurred last Friday, but well below 2014′s 3.48 billion average daily volume, which itself is declining.

Even so, the stock market’s “fear gauge” has dropped below 12, to its lowest level since 2007. The Chicago Board Options Exchange Volatility Index, or VIX, is an options-based measure of traders’ expectations for price swings in the S&P 500. Over the past 10 years, the VIX has averaged 20.

The lack of volatility in the broad market has occurred despite sharp moves in some areas that are relatively insignificant but have gotten a lot of attention, such as biotechnology, social media and some small-company stocks.

Another consequence of low volatility is that over the last three months, the spread between the S&P 500’s high and low points has been less than 5 percent. The last time a three-month range was narrower was in 2006. Historically, the average spread between the S&P 500’s high and low over three months is 13.2 percent.

Rising bond prices and sliding yields generally are considered results of an investor flight to safety. Yet the VIX at a seven-year low suggests that investors don’t feel the need to hedge their risks. Perhaps it’s because they’re underinvested in stocks.

Awash in Cash

But the big picture is that there’s so much global liquidity, with a lot of cash available amid sluggish economic growth to chase an inadequate amount of financial assets that can provide adequate income and capital appreciation. In other words, strong demand and short supply.

Some commentators warn that a low VIX reading indicates excessive complacency, with investors are failing to take full account of market risks. For example, they note that over the past two decades, 34 of the 50 lowest VIX readings came in 2006 and 2007, before the financial crisis exploded in 2008, eventually leading to the 63 highest VIX levels.

The counter argument is that we are in an environment of low growth, inflation and interest rates, and that the foreseeable future holds more of the same. Hence the evident predictability justifies both the quest for yield in fixed income and the ongoing appeal of stocks. It would also explain why investors continue to “buy the market dips” of 5 percent, say, instead of anticipating significantly bigger declines.

Meanwhile, quite a few commentators seem to think stocks have risen “too much.” Over the last 10 years, the S&P 500 is up 66 percent. But history suggests otherwise.

The S&P 500 started in 1928. Since the first 10-year period was completed in 1937, the average rolling 10-year return has been 103 percent. So the current 10-year gain of is only about two-thirds of the average.

Where does the current bull market stand in terms of duration and price appreciation? This is the 14th bull market since 1942. As of now, it ranks fourth in terms of length, at 1,908 days. It also ranks fourth in percent change, at 184 percent.

Meanwhile the economic recovery is one of the weakest on record, with the unemployment rate still well above the level when previous bull markets topped out. And inflation and the 10-year Treasury yield remain far below the levels in place at previous market peaks.

At some point, investor complacency will evaporate, bond yields will rise and stock prices will fall. But it’s currently unclear when that will happen.

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