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Are the markets too sanguine about risk?

Are the markets too sanguine about risk?

Concerns are rising that ongoing low volatility has left stock markets vulnerable to correction.

While the US is trading at new highs, with the Dow Jones having broken through the 17,000 mark at the start of July, and the S&P 500 has surged by 21% over the past year, the Chicago Board Options Exchange Volatility index (VIX) is at a low.

VIX, or ‘fear-index’ as it is commonly known, is a key measure of market expectations for near-term volatility, conveyed by S&P 500 stock index option prices.

Even though shares have surged, the volatility measure is down 13% year-to-date, and 19% over the past 12 months.*

Based on the price-to-book measure, US equities are now trading at their most expensive level since late 2007, while volatility is at its lowest level since early 2007.

Russ Koesterich, BlackRock’s global chief investment strategist, said: ‘For stocks, it is important to recognise the rally has pushed both valuations and volatility to extremes.

‘True, relative to bonds, stocks still appear to be the more attractive asset class. But investors should be cognisant that US equities are now fully priced and, as the low-volatility environment indicates, discounting little in the way of bad news. In other words, stocks are vulnerable if – or when – bad news comes.’

Continued loose monetary policy and a recovering global economy have helped deliver decent returns for nearly every major asset class in the first half of 2014. But Stephanie Flanders, chief market strategist of UK and Europe at JP Morgan Asset Management, believes the rally is generally "unloved", because investors know the days of cheap money and exceptionally low market volatility cannot last forever.

She said: ‘Investors are looking for things to worry about in the second half of the year, and geopolitics and US monetary policy are likely to provide them. But even with the prospect of short-term turbulence, we think the environment still justifies a modest preference for riskier assets.’

Fixed income markets have performed surprisingly well in 2014, in large part due to supply and demand dynamics for long-term government bonds, especially US Treasuries. Higher long-term demand for these "safe" assets is likely to prevent long-term yields from returning to traditional levels for some time.

‘Core fixed income markets are likely to come under some pressure in the second half of the year as the uncertainties hanging over the US recovery are lifted,’ added Flanders.

While US stocks are vulnerable to an exogenous shock, such as deteriorating events in Iraq, Koesterich continues to believe that, while bargains are few and far between, opportunities can still be found.

He added: ‘Japanese equity valuations, for instance, are currently among the lowest in the developed world despite Japanese stocks’ recent advance. At the same time, recent market-friendly actions by the European Central Bank could support European stocks over the next few months. For those looking to put new money to work, we would consider cheaper alternatives outside of the United States, including Japan, Europe, as well as certain emerging markets.’

*Source: FE Analytics as at 8 July, TR, US$ terms

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