An eerie kind of calm in the stock market – Santa Fe New Mexican

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A rare calm has settled over the stock market. Whether it turns out to be the one before the storm is a compelling question after a year of conditions so placid that investing has begun to look deceptively simple.

In all of 2017, the Standard & Poor’s 500 index experienced no decline greater than 3 percent, the first time that had happened. And a widely followed volatility index known as the VIX closed below 10 on more than 40 days in a six-month period through late November, according to Citi Research. Before that, the VIX had not closed below 10 on more than six days in any six-month period.

The peaceful trading backdrop helped the S&P 500 rise 19.4 percent on the year and 6.1 percent in the fourth quarter. Factoring in dividend payments and appreciation from the reinvestment of those dividends in the constituent companies’ stocks, the index returned 6.6 percent in the quarter and 21.7 percent throughout 2017. And, despite some rumblings in the bond market, stocks moved even higher in the early days of 2018.

But the drastically reduced trading volatility, a condition sometimes called metastability, worries some Wall Street strategists.

It’s not just that persistent buying has sent stocks to valuations exceeded only on a few occasions that preceded spectacular plunges. Billions of dollars have been committed to vehicles that seek to profit from the extraordinary degree of stability and depend on it persisting. If and when things change, the storm after the calm could be sudden and violent.

“Increasingly, people of a certain age who have seen enough cycles say: ‘We’ve been here before. We know the party’s going to end,’” said Rebecca Patterson, chief investment officer of Bessemer Trust, a firm that advises wealthy families. “It won’t end well.”

Last year ended well for domestic stock funds, with the average one in Morningstar’s database gaining 5 percent in the fourth quarter and 18.3 percent on the year. Portfolios that focus on technology, natural resources and economically sensitive consumer issues were especially strong in the quarter. Health care and real estate funds were noticeably weaker.

A stock market that never goes down except by a negligible amount — at least lately — has been widely perceived as less risky. Vehicles known as risk-parity funds seek to capitalize on the lack of price swings by allocating more money to stocks as volatility diminishes. Mutual funds that employ risk-parity strategies held about $8.6 billion at the end of 2017, according to Morningstar.

But nothing lasts forever. When the metastability ends and volatility returns to more normal levels, risk-parity funds will view stocks as riskier and begin to take their bets off the table. The more sudden the return of volatility, the faster the funds will sell. If it happens quickly enough, the market could go from metastable to not at all stable, turning a virtuous circle vicious.

“The whole thing could unravel very quickly,” Patterson said, although she is merely concerned, not alarmed.

“We don’t see enough red flashing lights to get out,” she said, “but we see yellow caution lights.”

For Komal Sri-Kumar, president of Sri-Kumar Global Strategies, the hue is more crimson.

“I see risk preference shifting significantly to risk taking,” he said. “The low-volatility trade is characteristic of a euphoric market.”

But, he added: “There are uncertainties present in global markets, and investors are also ignoring how highly valued equities are. They don’t seem to care. In terms of what the equity market is telling you, they have no concern that a problem or a massive correction lies ahead. They think central banks will save them.”

The bond market is sending a more unsettling message, Sri-Kumar warned. Despite steady and stronger economic growth in recent quarters and low unemployment, yields on long-term Treasury securities haven’t risen very much, even as short-term rates continue higher. That combination has led the yield curve, or the difference between short and long rates, to flatten.

The yield on 2-year Treasury issues at the end of December was 0.51 percentage points below 10-year Treasury yields, close to the narrowest spread in 10 years. The spread has widened slightly but if the yield curve should invert, pushing short-term rates above long-term ones, it would be an ominous sign, because an inverted curve often heralds a recession.

“It’s very instructive that the bond market is giving a completely opposite story,” Sri-Kumar said. “It has gone from being somewhat cautious to excessively cautious. I think it will invert over the next few months.”

The average bond fund rose 0.5 percent in the fourth quarter and 4.8 percent on the year.

“The fixed-income rally still has a way to run,” Sri-Kumar predicted. “If we do have a massive stock market correction, we will see the 10-year Treasury and investment-grade bonds going down in yield.”

He would reduce holdings of stocks and focus on defensive sectors and foreign markets, and he would allocate as much as 20 percent of a portfolio to cash.

The low volatility and overvaluation in the stock market have lasted a long time and might do so until a catalyst arises. That could be the continuing shift in Federal Reserve policy that kept short-term interest rates close to zero percent for nine years and led the central bank to buy trillions of dollars of bonds in its quantitative easing program.

The Fed has already raised rates five times in the past two years, including in December, and it announced in September that it would begin selling the bonds in its enormous inventory. The impact of such changes on the markets could depend on what investors focus on: how much support the Fed continues to provide, or how quickly it is removing support.