Should We Be Scared of Market Volatility?

When I go on vacation, I do so with the expectation that something will happen that makes me (almost) want to be back in the office.

Sure enough, while I was out last week, the market proceeded to sell off in a way that has become pretty uncommon recently, generating fear and worry.

Why it’s not time for serious concern—yet

The bad news: Following its big drop on July 31, the S&P 500 Index is now down about 3.3 percent from the peak. Technically, the index broke its 50-day moving average, at 1,954, and is close to its 100-day moving average of 1,912. Worryingly, the decline came in the face of better-than-expected earnings news, which suggests improving fundamentals may not come to the rescue. Not good news.

Or is it? At the same time, though, we’ve seen market action like this twice so far in 2014. In a historical context, this is normal volatility. Arguably, given the international issues—Ukraine, Gaza, Iraq, Argentina—we could have expected even more volatility. From that perspective, this relatively small decline is actually good news.

I don’t buy that explanation, even though I’m not terribly concerned yet. Looking at the big picture, market valuations are very high, based on expectations that will be difficult to meet. At some point, we will certainly experience a correction. The question is whether that is what’s happening now.

Are we seeing a correction?

The forces that drive up the market can be oversimplified as buyer enthusiasm, willingness to take risk, and availability of cash. When all three hit high levels, you know risk is high. When they start to roll over, the market may be in trouble.

That’s what seems to be happening, per a study by Market Extremes cited in a recent Wall Street Journal article. The article highlights three trouble signs:

• Investor enthusiasm, which can be proxied by the various bull/bear surveys out there, has come down from very high levels recently.
• Willingness to take risk, which can be proxied by the valuations of riskier sections of the market, such as small-caps, recently hit peaks and then declined.
• The breadth of gains (or the percentage of stocks that are increasing in price) has also declined.

And other analysts have come up with different metrics. John Hussman, for example, has focused on risk premia, which are also moving in a way that has negative effects on the stock market.

All of this indicates that we’re in a high-risk market, but it doesn’t mean the correction is starting now. Many of these factors have been in place for months or years. Here's what does worry me now: as the end of the Federal Reserve's stimulus program approaches, rate increases are becoming more and more likely.

What happens when cash isn’t so cheap?

The last piece of the puzzle for booming markets has been the availability of cash. Indeed, margin finance has risen to levels comparable with those of 2000, and above those of 2007. The availability of low-interest debt has allowed investors to borrow to buy stock.

With the Fed stepping back, the availability of cheap funds will, at a minimum, moderate—and may in fact decline. Higher rates, combined with more market turbulence, could set off liquidation, driving prices down.

Again, I’m not saying this is about to happen, but it is a plausible mechanism for a significant decline, and all the pieces are in place.

A moderate level of concern seems appropriate

As I’ve said before, I pay attention when technicals weaken, but I only start to get really concerned when we break the 200-day moving average. It’s not a magic number by any means, but it does indicate that we've entered an area where risks start to escalate in a disproportionate way.

I’ll certainly be keeping an eye on things, but I’m not all that scared yet.