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Op-Ed: Traders Are Remarkably Complacent Given Potential Dangers Ahead


This is the calm before the storm.

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It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you're not supposed to short a dull market but...
When volatility gets as low as it has recently, I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks. Bianco research recently noted that over the past 25 years, there has only been one other period where volatility has been as low as it is today: July 2007. That marked the beginning of a volatility pickup that ultimately peaked manifold higher during the height of the financial crisis.
Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this, it does suggest that investors are usually in for some sort of "surprise" that sends volatility higher. And there's a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.
It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security -- that stocks just don't go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the "great moderation" baloney. This causes them to become overconfident and overcommit to stocks. When a pullback greater than just a few percentage points finally happens, these investors are surprised by the "extreme volatility" (which is really just normal volatility that has been dormant,  and they reduce the exposure they put on when they believed volatility was dead.

Add this to the normal selling and you get a greater-than-average sell-off. Multiply all of these effects (to account for record low volatility) from the beginning and that's how you get a crash like we saw after the record low volatility in mid-2007.
Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations, and that's not about to happen again. But even if it doesn't repeat, history does look like it could be rhyming in some ways right now.
"Any major dude will tell you" about not just the record low volatility but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double-digit decline once this happened. And J. Lyons Fund Management shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles:

I know: Correlation does not equal causation.

Still, this makes a great deal of sense to me since margin debt is greatly responsible for inflating equity bubbles in the first place, and when it peaks, it's a good sign that the bubble has run out of fuel.
And we've seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, momentum names, and the Russell 2000 (INDEXRUSSELL:RUT) have all taken it on the chin lately even while the major indices have hovered near their all-time highs.
As for the latter, Urban Karmel noted late last week in his excellent Weekly Market Summary that, "RUT [Russell 2000] recently ended a streak of more than 360 days above its 200 dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead."

That level lies >5% below its current number, but there's a good chance stocks could fall at least twice that much.

He also notes:

At more than five years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended."

This doesn't mean stocks are about to fall 20%+. But with record low volatility over this span, how many investors are prepared for such a scenario?
There are also divergences galore: Todd Harrison has called our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing.

We haven't seen a divergence this large between "emotional buying" and rational buying since... you guessed it. Yep, 2007.
Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse, and this is typically a prelude to equity risk appetites reversing as well.

So what do junk bond investors see that equity investors don't?
Maybe it's that the latest episode of "reaching for yield" is about to come home to roost.
Maybe it's the weakness in retail. TJX Companies (NYSE:TJX), Home Depot (NYSE:HD), Whole Foods (NASDAQ:WFM), Best Buy (NYSE:BBY), PetSmart (NASDAQ:PETM), and others have disappointed investors over the past couple of weeks, and we all know consumers make up 70% of the economy.
Maybe it's the bursting of the bubble in profit margins.
Maybe it's the bursting of the housing bubble in China.
Or maybe it's just the fact that this cycle has run its course and is about to swing in the other direction.

Who knows?
In any case, I'd argue that the record low volatility shows that investors aren't looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They're expecting more of the same even though it's mathematically impossible.

But people love to believe things even when they know they're not true.

And you know what? According to the Fed, this is the very definition of a bubble.
It might not be your father's bubble, but just because we haven't matched the p/e's achieved during the Internet bubble doesn't mean that we aren't ridiculously overvalued today. And it's increasingly likely this is just the calm before the storm.

Editor's note: Jesse Felder has been managing money for over 20 years. He began his professional career at Bear, Stearns & Co. and later co-founded a multibillion-dollar hedge fund firm headquartered in Santa Monica, California. Today he works with a select group of clients at Felder & Company, LLC in Bend, Oregon, and blogs at

Twitter: @Minyanville

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