Within days of starting the third quarter of the year, U.S. stock market indexes were breaking records again and this time, they were also marking new milestones. The Dow Jones Industrial crossed over the 17,000 mark, nearly eight months after breaching 16,000 (the seventh-fastest 1000-point gain in the index's history); the Standard & Poor’s 500 was knocking on the door of the 2000-level; and 14 years after hitting the 5,000 level the first time around, the NASDAQ Composite seemed ready to recapture its old glory, just 12.5 percent below its record set in March 2000. You might think that the Wall Street cheerleaders would be out there celebrating with a noisy show, but something strange is going on…despite records, milestones and smart year-to-date gains, it’s eerily quiet right now, perhaps too quiet.
Investors are feeling mellow, according to the St. Louis Federal Reserve, which announced that its Financial Stress Index fell to its lowest level since the regional bank started tracking the data in 1993. Through the July 3rd close, the S&P 500 has gone 54 sessions in a row without closing up or down more than one percent, the longest such stretch since 1995. And the CBOE Volatility Index (VIX) -- often referred to as the “fear index” – closed at 10.32 just before the Independence Day weekend. To put that in perspective, the VIX soared above 80 during the financial crisis.
The VIX is down nearly 25 percent from the beginning of the year; is nearing its lowest level since 2007, when it fell below 10; and appears to be on path to challenge its all-time low of 9.31, reached on Dec. 22, 1993. Just because the environment seems calm, doesn’t mean that something bad is brewing. In fact there have been various periods when markets have been downright boring. But it would be unwise to let down your guard against the risks that are ever-present for investors, the biggest one of them all allowing your emotions to guide your decision-making.
A recent New York Times article called attention to something you probably already know: humans have physical reactions to extreme risk that can help protect us (touch that hot stove and your brain tells you pull it back in a hurry), but also can lead us astray. Author John Coates, explained that “under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion.” You may have experienced just such feelings in 2008 and 2009 and perhaps even sold everything in your portfolio to make those feelings go away.
The flip side of freezing up is getting lulled into a false sense of security. The current placid market conditions may allow you to gloss over the gyrations experienced during the financial crisis and subsequent bear market. Even more dangerous is the fact that a calm period can lead to a new round of risk taking. “When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking.”
Because human risk preferences can change as market conditions shift, you may be wondering, “How can I protect myself from myself?” The answer is clear: to adopt a diversified investment strategy that incorporates your risk tolerance, time horizon and financial goals. Let me state unequivocally: the strategy does not work perfectly in the short-term. When markets crashed in 2008 and 2009, almost every asset class plummeted in unison, and in the first half of this year, everything from stocks to bonds to commodities increased in value.
That said, asset classes might gain or lose value simultaneously for a period of time, but typically not by the same magnitude and not over a longer time horizon. During times of crisis or times of extreme calm, you may question the benefits of diversification. When you do, remember that when markets are either very noisy or quiet, the subsequent period may be far less so. Stick to your game plan – you will be happy that you did!