“It’s Different This Time” (Hint: It’s Not)

Karim Rahemtulla By Karim Rahemtulla
Options Strategist, The Oxford Club

Market Trends

The familiar refrain when the markets soar to new highs is “It’s different this time.”

The last time I heard this was just before the real estate market crashed in 2007. Before that, it was the dot-com collapse. Today, it’s the stock market in general.

Sure, there’s still a lot to be excited about…

Stocks are at record highs, and the economy is humming. Volatility in the market is at record lows, and it looks like clear skies ahead. Even the retail sector is picking up, and “Help Wanted” signs are staying in windows.

There’s nothing quite like a boom… until it stops. And it will stop – even this time.

Investors are infamous for their short memories. Terms like reversion to the mean, fundamental analysis, earnings growth, book value and the like mean diddly when the market’s soaring daily.

So let’s step back for a minute and take off the rose-colored glasses.

When volatility is at record lows, it’s not a good thing. It means that investors are complacent. To give you some background, volatility – as measured by the CBOE Volatility Index (VIX) – normally trades between 18 and 20. To understand this number better, think of it as a percentage.

It means that the S&P 500 Index has a 66.7% probability (one standard deviation) of trading 18% higher or lower than its current level over the next year. This is also called implied volatility.

When the VIX is above 60, it indicates that the market has a high probability of trading 60% higher or lower in the next 12 months. This was exactly what happened during the Great Recession. When the VIX hit 60 in 2008 and 2009, most investors were selling. The investors who had the fortitude to buy won the battle, as the market traded higher in the months and years that followed.

The lesson to be learned is that when the VIX is trading above 40 or 50, you should be buying, not selling. The opposite is also true, but with a twist…

Today, the VIX is at 9.7. This means that investors are betting the market will be either 10% higher or 10% lower in the next 12 months. Typically, this would indicate that investors should be selling. But since it’s different this time, investors are buying more and more.

TD Ameritrade reported earlier this week that the retail investor (you and me) has more exposure to the stock market than ever. Charles Schwab reported that customer cash balances reached their lowest levels on record. In other words, the crowd is all in.

At 9.7, the VIX is 50% below the norm. That is a huge statistic and should not be ignored. Put another way, the downside to the VIX is limited from here, while the upside is massive…

The twist is that the VIX can stay low for years as complacency, by definition, is not a quick function. So you may have a few weeks, months, or even a year or two when the market will do its best to lure you in. I can’t predict when that turn will occur. I can predict that it will occur, however, and that the carnage that will follow will be ugly, just as it always is.

The question you must ask in the face of all the mounting evidence that we are at very high valuations in the market is this: Do YOU believe it’s different this time?

I don’t. And I am certainly trimming my exposure to the market or using strategies that hedge my bets or allow me to buy select companies at much lower prices than where they are trading today.

I recommend you consider doing the same.

Good investing,