photo by Flickr user herval
A day or two before a hurricane strikes, the weather is often beautiful, with bright blue skies and nothing more than gentle breezes. Thus the expression “the calm before the storm.”
But sometimes a beautiful day is nothing more than a beautiful day, followed by a string of equally beautiful days. (Cynics will observe that we have a term for this phenomenon, too. We call it a drought.) Before we had radar and satellites, it was hard to tell whether a gorgeous afternoon presaged a big blow or just more of the same.
Similar conditions exist in the financial markets. Right now the skies are sunny, with most U.S. stock indexes at or near record highs (the tech-oriented NASDAQ remains well below the stratospheric levels attained during the dot-com craze), inflation tame, interest rates near rock bottom and, for the first time in around seven years, no large economy or financial system in crisis.
Should we be worried? I would say yes, we should worry at least a little, if for no other reason than that hardly anyone seems to be worrying right now.
I am not a Cassandra by nature. I’m not even a Nouriel Roubini, the NYU economist who foresaw the housing crash and whose persistently pessimistic forecasts thereafter earned him the nickname “Dr. Doom.” I don’t worry about short-term ups and downs in the financial markets, which are inevitable, or even about recessions, which are likewise inevitable and which are eventually followed by a return to growth. I like to think of myself as a realistic optimist. I know the future has a lot of sunny days, but I also know that they will be punctuated by occasional storms. I like to be prepared for them.
Five years ago, as the U.S. stock market began to recover from the crash that took the S&P 500 index below 700, most investors recoiled from those dirt-cheap stocks. Having dumped their original stocks, thus locking in their crisis-induced losses, these investors vowed that they would never again expose their “201(k)s” to anything more volatile than a Treasury bill or a bank deposit.
Fast forward to this week, with the S&P index above 1,900 and investors suddenly piling into stocks - but not only stocks. They have driven many bond yields down to levels not seen in a decade, even for risky companies. The rate on 10-year Treasury bonds this week has hovered near 2.5 percent. Consider this: the Federal Reserve wants to bring inflation up to 2 percent annually, and of course there is always a risk it could go higher. If inflation is 2 percent per year, and taxes on the 2.5 percent Treasury amount to 40 percent, the investor in a 10-year instrument is locking in an annual after-tax loss of about one-half of one percent. For a decade.
This is the kind of bond market you expect to see during a flight to safety, but as I noted, the same bond market is falling all over itself to shovel cash at irresistibly low rates to shaky or unproven companies, as well as to state and local governments that have huge unfunded liabilities and even to foreign governments, such as Spain, that are trying to dig themselves out of deep financial holes.
The corporate bond market is telling us things are dandy while the Treasury market wants us to fasten our seat belts. Treasury prices are probably reacting to an array of distortions, from the Federal Reserve’s ongoing loose-money policies to the new rules that encourage banks to load up on Treasuries to meet tough new capital requirements. However, there is at least a chance that these low Treasury rates are signaling that things could go south from here pretty quickly.
Then there is the VIX, officially the Volatility Index, but often referred to as the “fear index.” Generally, a number around 20 reflects a reasonably healthy stock market with average levels of caution; levels at 30 to 40 or higher indicate that fear has probably reached unreasonable levels and stocks are probably undervalued as a result.
Where is the VIX right now? Yesterday it was at 12. It has been below 20, and mostly below 15, fairly consistently since 2012, with only occasional spikes that coincided with market setbacks. Even Dr. Doom has now reportedly become an optimist. That alone is enough to make me a little concerned.
Financial markets have set their sails as though we are in for a long stretch of fair weather. This might come to pass, but there are a lot of things that can go wrong from here, too. Governments around the world have promised more than they have the resources to deliver. Geopolitical tensions are high and rising across the Eurasian land mass and the adjacent western Pacific. Low birth rates and aging populations mean less production and higher costs for years to come. Here in the U.S., we are still struggling to implement a disruptive health care reform, and we have not begun to seriously deal with our problem of unfunded entitlements. A single percentage point increase in average interest rates would add about $170 billion to our annual federal deficit, and interest rates are at least three or four percentage points below where they would be if the Fed were not artificially constraining them.
I’m not telling you to run for a safe harbor. Experience has demonstrated many times that trying to time the market is a futile exercise, but it is even more self-defeating to sell all your stocks after the market drops and then to repurchase stocks only after a big rise - which is exactly what many investors do.
But if you are not prepared to withstand some big swell, this would be a good time to reef your sails. Though things may stay calm for a while, in the financial markets as on the high seas, there is always heavy weather somewhere over the horizon.