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Is the Market’s Rush to Relax a Reason to Stress?

Is it possible to relax too much, too suddenly? And, if so, could this be dangerous?

Odd as these questions might seem in everyday life, they are exactly the ones Wall Street pros are asking as they try to decipher the stock-market action at the turn of the year.

The Standard & Poor’s 500 Index spurted 4.5% higher in the week straddling New Year’s Day, to a post-2007 high, with the small-cap Russell 2000 notching a new all-time peak. With this lift a collective, clenched-up investor tension released all at once, indicated in part by the historic drop in the CBOE S&P 500 Volatility Index, as hefty prices paid for downside options protection a week earlier were made to appear foolishly expensive in an instant.

Fear index sees record plunge

The VIX – on which futures and exchange-traded notes such as the iPath S&P 500 VIX Short-Term Futures (VXX) are based – fell a record 39% during the holiday-interrupted week. Its closing level of 13.8 was the lowest since 2007, aside from a couple of days last August.

There are many factors to weigh here involving calendar effects, an unusually specific deadline for a major government-policy threat and the usual parsing of economic data. The bottom line appears to be that the rapid shift from anxiety to repose evident in the markets poses the risk of a pullback – maybe a jarring one – in the very near term.

Through a broader lens, though, it appears the market is trying to gather the wherewithal to probe still higher, as the sense spreads among more investors that the economy and financial system are well along the healing process and that the low, gray ceiling of macroeconomic “uncertainty” is breaking.

One reason the price insurance as gauged by the VIX dropped so much is that it had increased more than 40% in the weeks before year-end – far more than actual stock-market volatility rose. Traders, loath to make many major changes to portfolios in a holiday-quieted market, paid up for protection in advance of the inherently unpredictable political fight over the Dec. 31 "fiscal-cliff" deadline.

A behavioral shift

In a major behavioral shift in the wake of the 2008 financial crisis, volatility-based products have become wildly popular in trading circles, despite their complexity and sometime misapplication, creating something of a new asset class called “the downside.”

Upon request, Bernie Schaeffer of Schaeffer’s Investment Research and Henry Schwartz of Trade Alert looked at all call options on VIX futures (which profit from higher VIX levels) traded in 2012 and determined that more than 95% of them expired as worthless. Many of these were used to hedge other investments, of course, and often they were sold or rolled over rather than allowed to be extinguished without value. But the ever-increasing volumes in these instruments into a steadily declining volatility trend show deeply ingrained anxiety among professional investors.

Whatever the mechanics of the move, historically such rapid evaporation of market-measured fear has served as a signal of a short-term “overbought” market that needs a rest or retreat to reset expectations.

John K. Harris, a stock market historian and keeper of The Wall Street Traffic Light, calculates that, as of Friday, the drop in the VIX’s 10-day average was among the largest nine ever since it debuted in 1986. On average, the other eight instances preceded S&P 500 declines of 5% or more within weeks.

Of course, this sort of history is no secret, so many this week are calling for a market pullback – perhaps even hoping for one in order to pick up equities cheaper after having come into 2013 positioned cautiously. Whether the market will oblige throughout the week – or serve up something nastier that feels worse than the gentle pullback many crave – is unclear, although we have started out on Monday in downside mode, with the Dow down around 70 points and the S&P down 7 in late-morning trade. But it’s worth noting that, when stocks have been in rally mode heading into earnings season, the market frequently suffers some turbulence during the reporting period.

The gathering conflict

Of course, the gathering conflict over the government debt-ceiling debate, set to climax in two months, is on everyone’s “risk factors” list. It’s a bit too far in the future for the market to fixate too closely on potential outcomes. And there is room for hammering out a deal of sorts, given the fudge factors involved in long-term budget projections. But until this is past, it’s unlikely that the average investor will add fiscal policy to the lengthening list of quelled crises that now includes (for now) system-calming monetary policy in the U.S. and Europe, a healing housing market and an agreement on tax rates.

Over a longer span, the relaxation of market fears such as just unfolded has tended to be more positive than not for the market over a multi-month horizon. With long-term investors representing the “slow money” still largely skeptical of stocks, there is at least a decent chance that this calm represents a move toward the “recognition phase” that most of the big, scary, known threats have been reduced, while not eliminated.

Of course, if so, this would be happening after stocks have been rising for four years, after corporate profits have doubled and will be tough to improve upon – and just in time for some other, unforeseen risk to arrive uninvited. It would probably mean that late-coming stock buyers would have missed most of the post-crisis upside in stocks, but not nearly all of it.