The Federal Reserve recently released the minutes of their mid-June FOMC meeting, which contained this ominous warning:
Corporate earnings growth had been robust; nevertheless, in the assessment of a few participants, equity prices were high when judged against standard valuation measures.
The big corporate entities may have recovered well from the recession, and their earnings growth is healthy; but that doesn’t mean that we’re not sitting in the middle of an asset price bubble right now.
The Fed also expressed concerns about future financial instability, driven by low market volatility.
Some participants suggested that increased risk tolerance among investors might be contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability.
And worst of all, it looks like even the Fed can see that their own policy attempts are not working. As they keep raising interest rates to tighten the market, they note with alarm at the continued ease of market conditions.
According to some measures, financial conditions had eased even as the Committee reduced policy accommodation and market participants continued to expect further steps to tighten monetary policy.
Yes, even the myopic Federal Reserve can see that we are in an asset bubble and are sounding the alarm. And the Fed isn’t the only ones.
The French financial regulator, the AMF, also recently released its 2017 Risk Outlook report. And a key risk highlighted was that:
High valuations and low volatility don’t reflect the level of economic growth nor the geopolitical uncertainty facing the market.
The report continues, noting that while stock markets have shown resiliency, there is a systemic threat from a sharp market correction. The AMF also notes with concern that “equity market volatility therefore now appears to be de-correlated from political uncertainty indexes”
As you can see, the EPU Index and the VIX have diverged; the VIX has remained low while the EPU Index has shot up. When the EPU Index and VIX are roughly tracking each other, this means that the market is acknowledging risk levels through the prices. However when the VIX is low but the EPU Index is high, this is what is called a “complacent market” situation; meaning that the market is underpricing risk.
This is not a new phenomenon by the way, Deutsche Bank notes that this VIX / EPU Index divergence has been occurring since 2012, as seen by this chart below which measures the residuals (differences) between the EPU Index and VIX.
However, it is quite clear that since 2016, the divergence has absolutely spiked. What this means is that one-sided risk continues to build up which of course increases the impact of any unwinding.
As Deutsche Bank notes:
Current levels of complacency are alarming. This is what everyone is talking about. Despite growing uncertainties and tensions, the market volatility refuses to rise. Persistence of low volatility is increasing the penalty for potential dissent and reinforces one sided positioning. As a consequence, the risk of disorderly unwind is growing. And the longer this regime continues, the lower the threshold of painful unwind.
Clearly, numerous parties are deeply concerned….
Yet despite all these warnings the market appears totally unmoved. Both the S&P500 and the Dow Jones Index have resumed their upward trend after some hiccups and now stand at literally the highest points in history.
If the market is indeed poised for a sharp correction, it is very important that you cover your downside. Intelligent investors are already covering their downside risk by selectively hedging their portfolios in safe haven assets such as gold and silver. Being long term stores of value, these assets can protect against the downside of not just equities, but also against inflation, bonds, and currency devaluations.
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