For those who tend to watch the stock market closely, you may have noticed that this has been a relatively calm year for the market. By the market I am referring to large stocks, whereas for small stocks there has been more volatility.
Oftentimes on the news you will hear commentators reporting certain indexes have moved a given number of points for the day. However, they often neglect to mention what that move is in percentage terms. A move of a 120 points may sound significant, but for an index at 16,000 that move is less than 1 percent, which is not a big deal.
There is an index called VIX that measures market volatility, and it is currently at its lowest level since 2007, which was just before the financial crisis. Normally the market performs well when this volatility index is low.
Some may be surprised given the developments in the world that market volatility would be low. We must remember that there are always some unusual events occurring, whether it be in the United States or other countries. It is just that the market considers some to be more significant versus others.
The relative calm we are experiencing in the stock market is also occurring in the bond market. The best way to consider risk in the bond market is with regard to spreads between Treasuries and Corporate Bonds. During times of market stress the spread widens, but during calm periods like now, someone only receives a small interest rate premium for a riskier bond.
The spread between Treasuries and high yield or “junk bonds” is at its lowest level since 2007, the same period when stock market risk was at its lowest. An index of high yield bonds currently yields just over 5 percent, but during the financial crisis, that yield exceeded 20 percent.
Obviously some investors find a 5 percent yield attractive when safer investments pay considerably less. However, on a historical basis investors today are not being compensated very much for the added risk that they are taking.
What investors are probably grappling with is that we are currently in a period of relative calm, but just a few years ago the market dropped 50 percent. In addition during the 2000 through 2002 time period the broad based S&P 500 also dropped a similar amount.
One point to consider is that 50 percent drops in the market seldom occur. Up until the year 2000, during the post World War II period, there was only one time that the market came close to dropping 50 percent, and that was during 1973/74 when oil prices quadrupled.
However, if we look at stock market history we will see that drops of 10 to 20 percent do occur rather frequently. No one knows how much longer this period of market calm will last. It could be a few months, or possibly several years, but eventually there will be a market correction again.
It is the same way with the economy, in that we will eventually have a recession again, but do not know when it will occur. Investors should also realize that we can have market corrections without the economy falling into a recession.
Investors need to realize that there will be periods of market calm, along with times when the market is very volatile. Just because markets are calmer today does not mean that risk has all of a sudden disappeared.
When you are not paid much to invest in risky assets, it is normally best to lower your risk profile. That means investors who want more return need to be patient. An example would be that yields on junk bonds currently don’t appear attractive enough for the potential risk. That means if someone is invested in that area, this would be an opportune time to reduce the position.