Market overview Q117: The calm before the storm?

With the exception of posting only modest performance in the first quarter of 2016, major indexes have been forging ahead with impressive consistency. The past quarter finished, as so many have of late, up with solid single digit returns. Correspondingly, the Financial Times reported that, "Several measures of actual and expected stock market volatility have fallen to post-crisis lows." Summarizing the landscape, the Financial Times added, "Whatever the headlines about Trump, North Korea or the shakiness of Greece and the uncertainty about European electorates, the surfaces of risk-market pools are remarkably calm."

A slightly deeper look into recent performance numbers, however, reveals some interesting disturbances. The Russell indexes, for example, show that the value style hugely outperformed growth in the fourth quarter of 2016 across each size category. The first quarter of 2017 provided almost a mirror image with growth hugely outperforming value. Such dramatic reversals are not normally accompanied by record low volatility. So what's the prognosis? Is it really smooth sailing for stocks or is this the calm before the storm?

A number of respected analysts, for their part, are not buying into persistently low volatility as a "green light" for investing. Citigroup's Matt King weighed in with his opinion, "Central banks appear to have succeeded in squashing the volatility and fear out of markets without removing the underlying risk factors themselves. The more markets rally, the greater is the potential vulnerability."

In addition, Jim Grant expressed his views in the Interest Rate Observer (March 24, 2017): "The avatar of tail risk—that would be the 45th president—has somehow managed to crash the VIX." Christopher Cole, founder of Artemis, a hedge fund that focuses on volatility, reported succinctly to the FT: "I'd be shocked if this market regime of low volatility endured."

The unusually becalmed landscape demands some explanations. An easy one is that investors are simply complacent. Evidence to corroborate this hypothesis comes in the form of sentiment surveys - many of which have been touching new highs. The InvesTech Research newsletter (March 17, 2017) points out, "The vitality evident in business is translating into confidence for the U.S. consumer as indicated by the Bloomberg Consumer Comfort Index. While this gauge hasn’t been as strong as in past economic cycles, Consumer Comfort recently moved to its highest level since 2007."

As John Hussman notes, though, sentiment is not an effective leading indicator. Quite the opposite: "'suffice it to repeat that consumer sentiment is actually a lagging indicator that can be predicted from past movements in indicators such as capacity utilization, inflation, and unemployment.' Put simply, elevated levels of consumer confidence are less a signal of forthcoming consumer spending as they are a signal of forthcoming investor losses."

Another explanation for unnaturally low volatility is the immense popularity of passive funds. John Dizard captured the magnitude of the phenomenon in the Financial Times: "We have created a bubble in average. Waiters and childhood friends are no longer telling us about miracle gold, oil, or tech stocks they bought at the right time. They are exchanging stories about low management fees on their index-tacking exchange-traded funds."