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Are Equity Investors Too Complacent?

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The stock market’s rise from its 2009 bottom has been strong and mostly void of long interruptions. Is it a warning sign of trouble ahead?

The CBOE S&P 500 Volatility Index (VIX) is one tool that measures fear and complacency in the markets.

The VIX tends to bottom, as it is right now, when complacency is high and fear is low. Conversely, equity markets are typically overstretched when the VIX is depressed.

Over the last five years the VIX has never closed below the 13 level, and the majority of the time the VIX traded above the 20 level.

This year, however, the VIX has already closed below 13 for the first time since 2007.

The VIX’s cousin, VXN, measures volatility of the Nasdaq 100 (QQQ) and here too, stock volatility is extremely depressed.  Now around 14, these volatility levels were last seen at its all-time lows in 2005, and, although that didn’t mark the exact top in the Nasdaq, it was a great level to purchase inexpensive volatility protection. 

Another hint about stock market sentiment is the Commodity Futures Trading Commission, which provides a breakdown of the “smart” money and the “dumb” money based on classifications of hedgers or speculators.  Over the long run the hedgers are usually on the winning side of the trade and the speculators the losing side.

In the face of the S&P 500’s (VOO) rally, hedgers have gotten more short in their equity positions.

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On the other side of the trade, Russell 2000 (IWM) speculators (the “dumb money”) are longer now than they have been in at least four years.

The previous time speculators were approaching this extreme of being long, was in February 2012, just before a 10%-plus decline in the Russell 2000 index.

One final piece of information that corroborates this data is the increasing size of leverage ratios.

According to Morgan Stanley (MS), margin debt among money managers and NYSE firms has risen to the highest level since February 2008.

While increased borrowing to buy equities is a sign of confidence in stocks, it can also be interpreted as a warning sign of frothy markets.

Although market extremes can last for weeks and years, they never last indefinitely. For that reason, advisors should be preparing their client portfolios for a market correction. Nobody knows when it will occur or how deep the reversal will be. But it will come.

The first line of defense is the right asset mix for each client. Thereafter, look at raising cash or hedging ETF positions with inexpensive put options or even inversely correlated ETFs like the ProShares Short S&P 500 ETF (SH).