Is the Market Irrationally Exuberant?

Advisors and investors should watch volatility closely, and beware of buying trends that aren't backed by strong fundamentals, experts note

Traders at the New York Stock Exchange. (Photo: AP) Traders at the New York Stock Exchange. (Photo: AP)

Now that the S&P 500 has broken all-time highs above 1,700, has the stock market’s mood gotten too giddy?

The SPDR S&P 500 ETF (SPY) has climbed 21.04% year-to-date, and that impressive rise has caused people to totally change their mind about stocks.

On Jan. 2, 36% of investors polled described themselves as bears compared to just 18% on July 10, according to the AAII Sentiment Survey. Put another way, the percentage of individual investors that are “bearish” on the U.S. stock market has been cut in half since the beginning of the year. What a reversal!

What about market volatility?

The CBOE S&P 500 Volatility Index (^VIX) is one of the easiest ways to gauge the stock market’s temper. It can tell us a lot. Over the past 12 years, the VIX has moved in the opposite direction as the S&P 500 around 80% of the time.

A depressed VIX can be interpreted as too much complacency or lack of fear in the stock market. Conversely, an elevated VIX infers a high level of anxiety or fear.

In a July 10 post, Michael Moran at the Chicago Board Options Exchange (CBOE) wrote: "Since 1990 the average daily close for the VIX Index was 20.3, but in the first half of 2013: the VIX average daily close was 14.2, and the VIX closed above 20 on only two days – June 20th (at 20.49) and June 24th (at 20.11).”

Really, the last two years have been a period of muted stock market gyrations. Since late 2011, the VIX hasn’t traded above 30.

VIX ETPs like the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath S&P VIX ST Futures ETN (VXX) continue to get crushed. And although the VIX has now marched toward 52-week lows near 11, market volatility is a sleeping giant that never goes away.

What about people going into debt to buy stocks?

NYSE margin debt hit a new all-time high in April, slightly exceeding the previous peak which coincided with the market top in 2007. We know that today’s modernized stock market has many of the safeguards that the 1929 market didn’t have, but excessive speculative borrowing is a red flag in any decade.    

Finally, frenzied penny stock buying is another warning sign.

The dollar volume traded in OTCBB stocks is already at 24,459,441,278 for the first six months of this year compared to just 13,295,767,536 for all of 2012! In other words, the public’s appetite for dicey penny stocks is insatiable.

From a contrarian point of view, none of this means that stocks can’t or won’t continue to rise. Prudence, however, means doing the opposite of the crowd.

Or as Sir John Templeton put it: “Common sense is not common; but common sense and careful logic show that it is impossible or produce superior investment performance if you buy the same assets at the same time as others.”   

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