The economy's fine, inflation's nowhere to be seen, deflation risk has abated, interest rates are low and fears over European politics -- Britain aside -- have so far proved unfounded. It's easy both to explain why markets have been celebrating, and why so many people are worried that everything's just too perfect.
The state of the economy easily explains high stock prices, low volatility and low bond yields. We're in what's increasingly being called a "Goldilocks" economy, which like Baby bear's porridge is not too hot and not too cold. Things have changed a lot since the term was coined in the early 1990s, as back then growth was a lot higher and acceptable inflation was about double the current level. But the principle is the same, with global growth reasonable and little sign of inflation that might push central banks into a sudden market-squeezing monetary tightening.
Explanation is not the same as justification. The fact that everything's been awesome recently is little guide to the future of the economy or inflation -- and the rise in stocks makes it less likely the general awesomeness will continue.
The market adage has it that markets climb a wall of worry and slide down a slope of hope. Worry has all but disappeared this year. As Simon Smiles, chief investment officer for ultra high net worth clients at UBS Wealth Management says, if the only thing to worry about is North Korea, there really isn't anything serious to worry about: "How does it get better than this?"
Of course, everything might continue to be wonderful. The geopolitics of Korea, Qatar and the South China Sea aside, it's hard to see anything especially threatening on the horizon. The trouble is that it's almost by definition the unexpected events that hit markets, and the calm has left investors less prepared for bad news than usual. As investors step further outside their comfort zone in the pursuit of gains, their resilience to bad news is reduced. The frothier the market, the less bad an unexpected event has to be to shake confidence.
A reasonable push back against this view is that there are few signs of irrational exuberance. This is not March 2000, or even October 1987. Robert Buckland, a strategist at Citigroup, says only two of his 18 bear market warning signs -- U.S. corporate indebtedness and global price/earnings ratios -- are flashing, which he says means investors should buy any dips.
It feels as though a lot of investors are waiting for dips to buy back in to the market, one reason that volatility has been so low. Anyone who waited this year has missed out on gains of 8.7% in the S&P 500 and 15.6% in eurozone stocks in dollar terms, painful for those who held back.
A look at the past can tell us a bit about dips. The S&P 500 hasn't had a 5% dip since the post-Brexit vote drop, only the third time since the mid-1960s it has managed more than a year without a pullback. The gaps between 10% corrections have sometimes been a lot longer; seven years in the 1990s and four years in the "great moderation" of the 2000s, compared with less than 18 months since the last such drop. But the real pain comes with a 20% drop, the usual definition of a bear market.
Investors like to believe that bear markets only come with recessions, and so reassure themselves that there's no sign a recession is imminent, repeating the mantra that "economic cycles don't die of old age." Unfortunately, this is both wrong and useless. First, 20% drops sometimes happen outside recessions, as in 1987 and 1966. Second, economic cycles can be killed by a financial crash, and as the late economist Hyman Minsky pointed out, the longer a financial cycle goes on, the more likely it is to turn to excess and end badly. Worse, there's no reliable method of forecasting a recession, so even if it were true that only a recession could end the bull market, that isn't a lot of use to investors.
There's no way to be sure when the next dip will come. Investing is about probabilities, and the chances of a nasty reaction to a relatively minor surprise are higher than they were -- but still not nearly as high as they've been at times of peak complacency in the past. When everything is awesome it's best to prepare for things to be a little less awesome in future, even at the cost of missing out on some of the gains if investors get still more complacent from here.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
July 06, 2017 11:20 ET (15:20 GMT)