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Is Investor Complacency a Bad Sign for the Markets Is Investor Complacency a Bad Sign for the Markets
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Is Investor Complacency a Bad Sign for the Markets?

Brent Schutte, CFA •  May 23, 2017 | Your Finances

Brent Shutte, CFAA seeming staple of the post-Great Recession economic and market advance has been the never-ending chatter about the “next” potential economic disaster looming around the corner. Deflation worries, crude oil’s plunge, U.S. earnings recession, China debt fears, Eurozone bank solvency woes, Britain’s Eurozone exit (Brexit), the U.S. election and, most recently, the French election (Frexit) are just a few of the headline-topping worries that we’ve waded through over the past few years. Despite every headline, the U.S. equity markets have remained resilient and pushed to new highs, and they are now being increasingly joined by international markets—which have been largely left out of the party so far.   

With the world economy expanding, U.S. and global earnings again rising, inflation remaining steady and no major elections imminent, many are now struggling to find the next big concern. While the recent U.S. political discord has created some market worries, most investors continue to shrug it off as noise. Perhaps reflecting this, expectations of future equity market volatility as measured by the Chicago Board Options Exchange Volatility Index (VIX)1 have recently fallen to levels last witnessed in 1993. Put simply, people who invest in the stock market appear to currently be at ease. The nay-sayers now believe that’s why the markets are about to drop—complacency. The story goes that if investors aren’t worried, then the equity market must be more susceptible to a downturn.

History suggests that people worried about complacency based solely on the VIX don’t have the substantiation to support their claims. A simple sorting of the actual data into different buckets of VIX readings shows that the S&P 5002 generally has higher than normal returns, is less volatile and has an increased probability of being positive in the year after a lower than median VIX reading. This may surprise some who have heard the mantra that the best time to buy is when others are fearful; but the data show that if one is using the VIX to define fear, above-average readings of risk have often lead to lower than average and more volatile future returns. It is only after investors have passed all the way through the emotional spectrum to being really, really fearful that future returns are indeed higher.

Of course, the above analysis is based upon simple averages of past returns, and the future can certainly prove to be different. And there’s the question of whether the VIX is even the right measure of investor complacency. Indeed, it’s hard to say whether investors are even complacent. I would surmise that if they truly were overly complacent about equities, then they wouldn’t still be buying bonds so aggressively at such low yields. Certainly, they aren’t euphoric. Indeed, the American Association of Individual Investors (AAII) sentiment survey3 just notched its record 123rd straight week when fewer than 50 percent of respondents replied they were bullish about equity market prospects.    

Broadly speaking, I continue to take comfort that so many detectives are looking for reasons why equity markets can’t go higher. How many times over the past years do you recall opening a research report or newspaper and reading an article on what could go right economically, rather than the current norm of vividly describing all the potential things that could and are going wrong? Until the narrative shifts to truly complacent and euphoric investors finding reasons why equity markets can’t go lower, sentiment will provide one positive tick mark in informing our overall positive equity market opinion.

1VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely-used measure of market risk and is often referred to as the “investor fear gauge.”

2Standard and Poor’s 500 Index® (S&P 500®) is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

3The American Association of Individual Investors is an independent, nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research. The AAII Investor Sentiment Survey has become a widely followed measure of the mood of individual investors. The weekly survey results are published in­ financial publications including Barron's and Bloomberg and are widely followed by market strategists, investment newsletter writers and other financial professionals.

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The opinions expressed are those of Northwestern Mutual as of the date stated on this publication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Sources may include Bloomberg, Morningstar, FactSet and Standard & Poor’s.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

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