Bouncing the Reality Check

Don’t let the stock market’s seeming indifference to recent events fool you; there is a lot more risk present than its recent record high levels might suggest. The appointment of a special counsel in May to investigate President Trump’s alleged collusion with Russia merely set the market back a single day, indicating a negative outcome was either unlikely or irrelevant.

That optimism also is reflected in the stock market’s performance for the first five months of this year, as the S&P 500 Index increased by 7% despite gaining no new ground for all of March and April. But the index increased nearly 1% in May due to a solid set of first quarter earnings reports combined with a strong jobs report. Asset values are up, unemployment is down, and it seems nobody is overly concerned that so far almost none of Trump’s pro-growth legislative priorities have passed into law.

If I have learned anything over the past 35 years of investing, it is there is no way of knowing in advance just how fast, or how far, the stock market might fall when it starts to unravel. For example, in 1987 the stock market suffered one of its worst declines in history, when the Dow Jones Industrial Average fell 22.6% on October 19. Today, that same percentage loss would equate to a decline of over 4,000 points in the DJIA in a single day!

Surely, if an accurate measure of risk had been available at that time, the stock market would have already adjusted to it, leaving considerably less room for a sudden movement one way or the other. For that reason, a lot of attention is now being given to the VIX, or “fear index,” that converts the level of activity in index options into a numerical measurement. If the VIX is to be believed, the stock market is less risky now than it has been at any time during the last five years.

The simple fact of the matter is the myriad elements of the global financial system are interwoven to a degree that no statistical model can fully encompass. For that reason, I don’t trust the VIX and neither should you, as explained in the June 14 edition of Personal Finance.

Of course, you can find highly regarded stock market analysts who will argue precisely the opposite. Two weeks ago, Nobel Prize-winning economist Robert Shiller stated on CNBC that he believes the stock market in not overvalued and “could go up 50 percent from here.” No disrespect to the Nobel Prize or the people to whom it has been awarded, but two Nobel Prize winners were involved in the collapse of Long Term Capital Management 20 years ago, which nearly brought down every major Wall Street investment banking firm with it.

In 1999, a pair of respected financial journalists co-authored the best-selling book, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market, which may prove true eventually, but thus far has fallen well short of that mark. Two years later, the stock market crashed in the wake of the “dot bomb” collapse. That same year, the book Dow 30,000 by 2008; Why It’s Different This Time proved to be one of the most ironically titled books ever, as the stock market once again crashed in spectacular fashion during the year specified in its title. 

All of these people were presumably well intentioned and sincerely believed in the accuracy of their predictions. However, the very nature of risk is to be unpredictable. Otherwise, it would be nothing more than a quantifiable cost that could be transferred to another party in exchange for a modest premium payment. But it cannot, and attempting to view it as such by using the VIX as a proxy for downside risk is a dangerous game. 

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