Respect the trend - but are investors too complacent?

I don’t want to scare away investors entering the stock market right now, as it has been doing much better now than it has in a long time, and there is really not much to gain from the normal alternative investment in government bonds – at least if you don’t want to hold the very risky ones.

Nevertheless, I see very few signs of investors paying attention to the risks in stocks as measured by VIX, a measure of the pricing of the volatility in options quoted on the exchange. To me, it is a warning signal if options traders request lower volatility than what the market has been trading of late.

Chart 1 shows that we are in an unusual period at the moment. If I go back to the early 90's and measure how often the quoted volatility (VIX) is above the 3 month realised volatility it shows this is the case in 88 percent of the time. The VIX was over the four month period from November to February 2012 lower than the market. But this was after a reversal of a spike. What we see today is again a lower VIX than the realised volatility but now at a very low level. I see this as a warning sign - there's just too many complacent investors.

Vacation period – no noise from decision makers in the US or Europe
We are now exiting the period where decision makers have been on vacation but where investors are still scrambling to get a decent yield. As such, I see investors being reluctantly sucked into the stock market. If I am right, I suspect that the latest investments will be sold quickly with the panic button nearby – just in case.

Going forward investors hope some real solutions to the financial crisis and not just talk of such will come soon. In the US we have an election ahead and a Federal Reserve unwilling to move as long as things are reasonably fine. On the back of the election we have a fiscal cliff approaching, which is not a nice thing if you are invested in equities. Bond holders in contrast would probably be pleased about this.

In Europe, similar topics more or less abound. A slew of meetings are coming up and I do not expect a straight road to full European quantitative easing (QE). There are too few check-marks to please Frau Merkel and the Bundesbank. So it will not just be a matter of 'signing on the dotted line'.

Looking at the S&P500 and the VIX the correlation is still very high, see chart 2.

If we enter a more normal situation of VIX being higher than market volatility - as per normal -  and on top of this also see realised volatility increasing then I would expect the market to initially decline to 1350-1400. If the level in VIX forcefully changes then the market would head for 1250-1300, given the relationship continues.

Conclusion
I do not envy investors being dragged into more risky assets than they are comfortable with but this is my best guess about how things stand at the moment. Many risks abound but yields are just not good enough. Central banks are probably satisfied for the moment as higher stock markets look “good” on their books regardless of whether valuations are creeping up.

While we are waiting for the pop or just following the crowd into stocks we could perhaps listen to Aretha Franklin “Respect”.