If you are an engaged investor and trader as I am, the thought has to have crossed your mind lately just how much longer these market highs can go on. What risks to continued appreciation of stock prices exist in the market and what events might trigger a significant event? We’ll look at some sources of concern and what impact they might have.
Prolonged Complacency Inherent in the VIX
One of the first risk-profile components I invariably look at is the VIX index. I know based on whatever level the VIX is holding what level of concern sophisticated investors have about current versus future prospects. We have this understanding because at some level this indicator reflects the amount of hedge against market corrections major participants have accumulated. A low level of this index suggests reduced demand for stock price insurance, and hence suggests that a near-term pull-back is not likely priced in to current market levels. We have been at just such a (relatively) low level state for a considerable amount of time now, and that has me concerned, particularly as the Federal Reserve’s Quantitative Easing program ends (again). The last time the FED shut off QE, the market did not do very well – resulting in a resumption (and expansion) of the program multiple times since 2008. Here’s an annotated look at the VIX since the dot-com bubble burst in 2000-2001 (source data Yahoo! Finance).
Developed Nations Interest Rates Remain at Historic Lows Globally
The second concern I have with regard to global markets is the interest rate flatline, also effectively ongoing since the adjustments related to the Lehman collapse. Can you believe we’re still talking about that 6 years later (this September)? And yet here we are. That is simply how badly mis-managed the financial markets were in terms of counter-party risk exposure resulting in nominal dollar amount contract exposure when all the derivatives markets blew up on the sub-prime loan defaults. Here’s a look at the current funds rates in the leading developed financial centers (Japan, US, EUR, GB) and elsewhere. Some countries have experimented with negative rates yet still negligible growth. BRICS nations are slowly developing alternatives to trading with the US as an intermediary for both geopolitical and economic reasons.
Margin Levels Peaking Again
A third area of concern typical during market booms is the level of margin exposure (particularly in relation to net equity positions). We don’t have a global breadth of data on the topic, but we do see periodic statements of NYSE margin participants – and those results and signals have been reasonably telling (predictive) in the past. I won’t bother to reinvent the wheel here as others have already nicely posted this chart and analysis but the message should be obvious: here again is another red flag.
Major Powers Geopolitical Conflicts Threaten Global GDP Growth
Ukraine. Libya. Syria. Iraq. Gaza. Those are just the hot-spots right now, let alone the threat posed by a potential nuclear Iran or unrest in North Korea or China. Heck, we even had a several week long uprising in Missouri not to mention an employee revolt against the ownership of Market Basket in northern New England. There is a bubbling tension from disenfranchisement both globally and even now domestically. Participation in equities markets (at least as measured by trading volume) stands at decade-old lows. Labor workforce participation rates continue to fall in the US and Europe. Wealth and income gaps continue to grow. Political leaders remain aloof and uninterested in solving any of the basic economic problems of the day.
What Is There to Be Optimistic about in 2014
I honestly do not have a good answer for this. Usually financial crisis tend to start outward in the emerging markets and work their way in. Argentina’s default is one event. Spain has shown signs of stress over the summer. The ECB just did a rate cut… and then just when you think things will have settled down in Europe, Greece or Italy will blow through their funding resources again.
And just in case you thought the US 4.1% GDP growth was a good buffer against global growth issues… wait until all those sub-prime auto loans come due (and end up delinquent). If the VIX chart above is any indication as to how the next series of negative market events will unfold, we can expect the fall from current market highs to be swift and brutal. We’ll have to see how the market handles the loss of the
Greenspan Bernanke Yellen put.