What a ride this year has been in the markets. Volatility has been sucked out like water through an unplugged drain, any bad news has been quickly absorbed and discarded, and equities keep gliding to the upside. During this Bull Run, the market has climbed an enormous wall of worry, and has found a way to look more constructive along the way (for example, the S&P 500 broke out of the 2010/2011 range, most global markets recaptured positive trends, and the much maligned financial sector is participating in the current uptrend).
All of this has been good news for investors, so what could go wrong? The biggest problem we currently face seems to be that the markets are recognizing too much calm and good news – that’s actually a contrarian sign that markets are overdue for a well-deserved break. True, we’ve touched on complacency all year to no avail, but current sentiment in the markets appears to have gone from complacent to really complacent (a highly technical term, I know) and the rubber band is looking ready for a short-term snap back. History is on the side of a market breather, and Ned Davis Research just put out some stats that make the case that we are hitting the typical window for a second quarter pullback.
In the long-term, I still believe there’s a deep undercurrent of public distrust regarding markets, which ultimately should be constructive and give the market room to keep climbing back toward the 2007 highs of 1560. However, in the short term the bull market may be setting up for a detour consisting of some combination of price and time, as the institutional market seems saturated and in need of a shakeout.
So how do we position for such a consolidation? In this case, since the expectation is for a pullback within a bull market (and not a major turn and bear market), our best bet is to be patient and look to upcoming volatility to complete our migration back to benchmark levels. As always we’ll have to watch for red flags regarding system risk, and separate scary noise from actual signals of an impending major market turn. Assuming that prices are the only things that materially change, the plan will be to use any potential scare to put us squarely back on neutral volatility with our benchmarks.