"Is Complacency Returning to the Equity Market?"

Sydney M. Williams

Thought of the Day

“Is Complacency Returning to the Equity Market?”

February 9, 2011

The last time the DJIA had a daily move of more than one and a half percent was December 1. (The S&P 500 declined 1.7% on January 28, but the Dow Jones fell 1.38%.) Since the first of December, the Averages have risen eight percent in a remarkably stable fashion. We have to look back to the first half of 2007 to find a similar period of such low volatility. Complacency was certainly prevalent at that time, despite forebodings of inclement weather. The question is: in this time of low volatility, has complacency reappeared?

The Federal Reserve has kept the Fed Funds rate at 25 basis points since December 16, 2008. The Fed began lowering rates on September 18, 2007 and persisted for the next fifteen months. (The Discount Rate was first lowered preemptively on August 17 of that year.) They have chosen to keep their foot on the pedal because unemployment remains high and because Mr. Bernanke continues to worry about the prospect for deflation, despite indications that the economy is recovering, though admittedly at a below average rate. During the same time, the Fed’s balance sheet has expanded by $1.5 trillion and government debt by almost $5.0 trillion. (A cynic would observe that low interest rates serve he who is issuing debt, while harming the prudent saver.)

Some of that money has gone into assets, fueling the price surge in commodities, stocks, bonds and bank loans – a goal of the Fed. Stock prices are now up 98.6% since bottoming on March 9, 2009. The decline and the first year of recovery saw high levels of volatility. During 2008, for example, there were 116 days when daily volatility of the DJIA exceeded 1.5% – up from 51 days in 2007, of which 45 days fell in the second half. During 2009, there were 61 such days, of which 47 were in the first half. Last year was a more normal 33 days.

Despite the Fed’s activity, Treasuries have fallen since year-end, as have Investment Grade Corporates. However, stocks, since the end of December, are up 5.3% and the CBOE has risen 4.0%, despite gold being down 4.1%.

Risks always confront investors. Today we have our share – persistent high unemployment, federal and state debt, unfunded pension and health plans, sovereign risk, excessive regulation, the Middle East and East Asia (North Korea) and the possibility (probability) that rates go higher. All of these, with the exception of the latter, are discussed ad nauseum in the Press.

Over the past ten or so years, the Fed has been late to react. For example, despite the tech-internet bubble beginning to deflate in March 2000, the Fed did not lower rates until January 2001. The stock market bottomed in October 2002, yet the Fed continued to lower rates into June 2003 and only began to increase them in June 2004. Despite rapidly rising home prices in the mid 2000s, the Fed finally raised the Funds’ rate to 5.25% in June 2006, but 125 basis points below where they had been in the summer of 2000. In my unprofessional opinion, they are keeping rates too low at present, helping to fuel asset prices, including equities and abetting complacency.

The difference, in my opinion, as regards the sense of complacency today versus four years ago is that four years ago few commentators were talking about the situation. Today it is the subject of numerous market seers. The stock market had made its low in the fall of 2002; four years of good performance dulled the critical eye of most investors, lulling them into ignoring warning signals. We also know that that calm preceded one of the greatest financial crises in history – an event, in my opinion, unlikely to be repeated, at least over the foreseeable future, despite the plethora of risks we discuss daily, in part because that recent experience is so deeply embedded in our psyche.

So, I conclude that we must be conscious of the decline in volatility and the complacency it might portend. I see it as an amber light, a shot across the bow. There is little question that performance over the next few years will be substantially below that of the last two years – an extraordinary period in financial markets, just as the preceding two years had been. But I also don’t believe the markets are selling at multiyear highs. After all, despite the almost 100% returns to stocks over the past two years, the S&P 500 is still selling 15% below where it was eleven years ago. And, in my opinion, we are not Japan.