To some observers, U.S. stock market investors are whistling past a graveyard.
Upbeat analysts might say that’s hyperbole, given that major stock indices are at near record highs, while the benchmark VIX volatility index — the so-called “fear index” — is at multiple decade lows.
The Dow Jones industrial average is up 19.3 percent on a year-to-year basis and nearly 6 percent on a year-to-date basis. The Nasdaq composite has 30 days of record closes in 2017.
[See: 8 Times When You Should Sell a Stock.]
In a recent report, Bank of America Merrill Lynch states that 34 percent of professional investors surveyed say stocks are “overvalued” — the highest number in 17 years.
The VIX volatility index, meanwhile, dipped below 10 on May 8, the first time it hit single digits since January 2007, indicating that investors are unconcerned about market conditions. By contrast, the VIX reached nearly 60 in October 2008, in the midst of the Great Recession, and topped 28 on Aug. 24, 2015, a day in which the Dow shed 1,000 points in morning trading. As market volatility goes increases, the VIX goes up.
Given these historic, and potentially over-inflated stock market conditions, are U.S. stock market investors playing a dangerous game by being indifferent to market risks? More specifically, are investors in relaxation mode, as a chorus from the Federal Reserve to Vanguard founder Jack Bogle say the market is overvalued?
“I’d say so. U.S. investors seem very complacent with the U.S. stock market,” says Jonathan Monjazi, founder of CEO Based Investing in San Diego.
Monjazi says many investors may feel the good times will continue forever after a near decade bull market.
“There is a risk in complacency, however, especially for those investors who are heavily invested in the U.S. stock market and nearing retirement,” he says. “Complacency can be a real danger. This is especially the case for passive investors who may be doing very little to protect their portfolios.”
At his firm, Monjazi says he’s not waiting around for the storm to hit.
“We do have some clients who are very concerned about rising interest rates and the possibility of higher rates causing a recession,” he says. “This caused us to reduce their exposure to stocks and diversify toward cash and other short-term notes, so that their upcoming retirement goals are not affected.”
He’s not alone.
[See: 7 Stocks That Soar in a Recession.]
“Yes, investors are too complacent,” says Adam Grossman, a financial planner with Mayport in Newton, Massachusetts. “When the market has been going nearly straight up for more than eight years, we all get lulled into a sense of safety. It’s really hard to imagine that the market might go into a correction when everything seems to be going so smoothly — just as it was approximately 10 years ago, right before we hit the financial crisis.’
But that’s precisely the problem, Grossman says. People just can’t predict market trends, and that includes investment professionals.
“Recall Queen Elizabeth’s challenge in late-2008 to a room full of economists: why did no one see this coming?” Grossman says. “Investors just have no idea what’s around the corner. Professional Wall Street forecasters spend their days issuing forecasts, but they really have no idea. They can only look at the data in front of them — GDP, industrial production, etc. — but it won’t, and can’t, tell them whether another financial tsunami is about to happen.”
The solution? Grossman says since no one knows the future, and it’s absolutely possible that the market could decline 50 percent as it did from 2007 to 2009, investors should be prepared.
“Specifically, they shouldn’t be sailing along at 80 percent equities in their portfolio if they couldn’t stand a market pullback,” he says. “They shouldn’t try to time the market, rather they should have an appropriate asset allocation that will allow them to weather whatever surprise event is around the corner.”
What are the dangers of market complacency?
For John Weninger, founder of Vision Wealth Partners, in Appleton, Wisconsin, the first risk is that asset allocations are out of balance with an investor’s risk tolerance.
“When equity markets grind higher, equity balances now account for a greater overall portion of the portfolio,” he says. “This is a risk because when the market goes into correction, a larger portion of the portfolio is at risk of loss. Investors should make sure they are allocated in line with their risk tolerance.”
Investors can also suffer from optimism bias, where they subjectively have greater confidence in their investing abilities than what is objectively true, Weninger says.
“Like men who believe they are better drivers than women, investors need to avoid reaching when investing and acknowledge your own biases where they exist,” he says.
Maybe the best question to ask is one offered by Weninger: How would a 20 percent stock market correction impact your future goals?
[See: 10 Skills the Best Investors Have.]
It’s a great query to ask right now, and if you’re too relaxed to give the matter some thought, and can’t act “swiftly and decisively” to prepare for that scenario, then your financial future could well be in jeopardy.
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The Fear Index: Are Investors Too Relaxed? originally appeared on usnews.com
