Through November the S&P 500 index was up 29% for the year. Barring a significant countertrend in December, 2013 will be one the best years for stocks since the 1990’s. If you factor in the abysmal performance of European and emerging market stocks with gold (down 27%) and the fear that bonds will be decimated when the Fed begins to increase rates, it looks like US stocks are the only place to invest.
This creates questions for investors. Do I keep my money invested in stocks or do I sell? If I sell, where do I reinvest? Should I add new money to the stock market now or wait? In previous articles, we highlighted the large cash pile that legendary investor Warren Buffett has amassed at his company, Berkshire Hathaway. We have also highlighted the Feds efforts to make stocks the only game in town and we’ve highlighted the growing disconnect between economic conditions and stock valuations.
For today’s discussion let’s focus on measuring volatility and how it affects risk. We will define risk simply as “loss of capital”. As stocks increased this year, the CBOE Market Volatility Index (VIX) which measures implied volatility versus historical volatility, declined by 30%. This demonstrates that investors have become less worried about downside risk than they were previously. We can further confirm this complacency by looking at margin debt which just hit an all time high in October.
High net worth investors are using borrowed money to buy more stocks than they have the cash to afford on their own. The Fed is fueling this buying binge by allowing these well heeled investors to borrow money at historically low rates. Our credit driven stock market is an analog of the housing bubble. From 2005 to 2007, real estate was the only game in town in places like South Florida, Las Vegas and Southern California. Until credit evaporated leaving unfinished developments, bankrupt banks and foreclosed properties.
Margin investors don’t have the benefit of delaying their debt repayments through a lengthy foreclosure process. When a margin call is triggered they only have a few hours to cover their debt or they get sold out at whatever price the broker can get at that instant. The same psychology that existed in real estate speculators (prices never go down) has appeared in margined up stock investors (the only game in town). When investors care more about upside volatility than downside volatility, problems ensue. Isn’t it simple prudence to prepare for a similar resolution to this behavior?