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Watch for Volatility Ahead Amid Blue Skies and Market Complacency

Mature overextended bull markets create optimism and expectations. More than that, they create investor complacency.

Mature overextended bull markets create optimism and expectations. More than that, they create investor complacency. All the painful lessons of the previous bear market are either forgotten or written off as a one-time event, cautions Jim Stack, money manager and editor of Investech Research.

In the absence of any residual recessionary storm clouds, the outlook is for “blue skies” as far as the eye can see So it’s no surprise that a recent University of Michigan consumer sentiment survey reveals that investors have seldom — if ever — been more euphoric in their outlook for the market.

In fact, the percentage of respondents expecting an increase in stock prices is higher than any time since the survey began in 2002… and possibly even as high as the Tech Bubble of the late 1990s.

Another related extreme exists in current stock market volatility — or actually lack thereof. One would have to step all the way back to 1972 to find a year with this few 1% moves, plus not a single 2% gain or loss.

Historically, low extremes in volatility exhibit complacency and often precede bear markets: 1972 preceded the biggest bear market since the 1930s.

While we are still onboard with the current bull market outlook, we want to prepare you for the volatility ahead and the scenario under which it might unfold. Since the Presidential Election, confidence in the U.S. economy has been both pervasive and unequivocal.

As this bull market grinds higher, confidence continues to abound. For many investors, it is hard not to feel invincible when most assets are advancing in unison.

While the leading economic data shown on this page remains remarkably positive, it is this type of far-reaching optimism that we have historically seen at or near previous market tops.

Consumer sentiment as measured by the University of Michigan confirms that consumers are feeling extremely positive about the economy. Both the “Current Conditions” and “Expectations” components are currently at or near their highest levels since the Tech Bubble of the late 1990s.

Our key indicators in breadth and leadership are still firmly on the bullish side. Yet aging economic recoveries invariably lead to excesses and a dangerous sense of complacency among investors.

The overall Purchasing Managers Index rose decisively to its best level in 13 years, while the New Orders Index remains near expansion highs and bodes well for future business spending. However, we are nearing or at the point in this recovery when “good news” may be bad news for investors.

We have looked at the performance of the S&P 500 following a jump in the ISM Purchasing Managers Index above the 60% threshold. The results, on average, show meager stock market gains over the next 3, 6, and 12 months.

In fact, the average 12-month gain since 1960 has been negative! Consequently, it is dangerous for investors to extrapolate strong economic reports into strong future investing profits.

The strength in the economy, and particularly upward pressures on wages from an extremely tight labor market, could inevitably lead to higher inflation. For now, the headline CPI remains subdued. However, alternative measures suggest that underlying inflationary pressures are bubbling just beneath the surface.

So, while further bull market gains are likely in the months ahead, it is critical to keep an eye on emerging inflation pressures and watch for technical divergences that could herald an eventual turning point.

We are heading toward higher volatility in the year or two ahead as this bull market eventually gives way to the next bear. Both 1% and 2% daily moves in the DJIA will become more common, and a few down 500 point down-days are all but certain. Our objective is make sure your portfolios are more defensively positioned before the full storm of the next bear market strikes.

Jim Stack is editor of Investech Research.

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About Founded in 1981, MoneyShow is a privately held financial media company headquartered in Sarasota, Florida. As a global network of investing and trading education, MoneyShow presents an extensive agenda of live and online events that attract over 75,000 investors, traders and financial advisors around the world.

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