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Sure, Stocks Are Rallying, But Are Investors Too Bullish?

The stock market's path to prosperous times ahead is unlikely to be smooth, with increasing volatility along the way and hazards both domestic and foreign.

Source: houseofplum.com

While the new year begins with most strategists expecting big things, a recurring theme is that investor complacency is nearing an end.

The market's main fear gauge, the CBOE Volatility Index, is just above its holiday season lows and around a level last seen in April 2010, before sovereign debt concerns drove a summer-long slump in stocks.

Indeed, market pros have their eyes open for any number of obstacles that could make the journey higher a bumpy one.

"While stocks should be boosted by good economic news flow, a variety of troubling factors...could all contribute to fairly uneven progress for the S&P 500 with a number of spikes and dips for investors to navigate," Tobias Levkovich, chief investment strategist at Citigroup, wrote in a research note for clients.

Among the most commonly mentioned hazards include European sovereign debt, concerns regarding overly accommodative Federal Reserve policythat may not last, as well as political instability that could come about should President Obama and the new Republican-controlled Congress start to clash.

But there are technical factors at play, also.

Technicians fear that such a low level of investor fear, as expressed through the VIX, is simply unsustainable and indicating that any type of shock at this point could send the market reeling.

"What we know is that when the VIX gets down to this level, it's a period of instability," Jim Strugger, derivatives strategist at MKM Partners, said in a recent CNBC interview. "What exactly triggers that shock could be almost anything."

A chart analysis shows the VIX is about three and a half years into a five-and-a-half-year cycle of high volatility. The recent dip in investors fear is merely a break in "another two years of the high-volatility regime," Strugger said.

As a matter of investment strategy, Strugger says investors should be looking at some of the other volatility instruments that offer longer-term protection against market shocks. Some include the iPath S&P 500 VIX Short-Term Futures and the same iPath Long-Term Futures exchange-traded notes.

"I would be buying volatility down here given how cheap it is," said Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "That said I would probably be looking to hedge some of my equity positions through the options markets with earnings coming right around the corner."

Lutz sees health care as being an especially volatile sector and says he'll be watching the upcoming JPMorgan health care conference for clues about the industry's direction. Republicans have been rattling sabers about repealing the so-called ObamaCare nationalized health plan, and that could make industry stocks unstable.

Indeed, volatility will be about more than that which can be measured through the VIX, which by design is a fairly simple options buy that protects against movements in the market. However, the VIX usually has an inverse relationship with the market, meaning that when stocks are up the VIX is down.

But true volatility is a many-faceted phenomenon that poses a number of challenges for investors. By other more accessible measures, the market has been in a long-standing state of volatility that is likely to continue.

For instance, the S&P 500 has risen or fallen by 2 percent or more in a single day an average of just five times a year since 1950. However, that has happened an average of more than 14 times a year in the last 10 years, and spiked at 54 times during 2009, according to Sam Stovall, chief equity strategist at Standard & Poor's.

Looking at the recent trends in when the market hits tops and bottoms, this one could have a ways to go before it reaches a bottoming point, based on volatility trends.

"So if history should repeat itself, and there's no guarantee it will, the S&P 500 may have to endure another dip deep into negative territory before the rolling 10-year performance finally bottoms during this secular bear market," Stovall wrote in a note to clients.

Citigroup is among the firms that also believe the market will finish 2011 higherbut faces a treacherous path there. The firm has raised its full-year target for the S&P 500 to 1,400 and its Dow target to 13,150.

But Levkovich said he worries that too many investors are relying on historical trends, such as the market's usual outperformance during the third year of the presidential cycle, as reasons to believe the market has nowhere to go but up.

As such, he believes investors are going to have to be quick on their feet this year and willing to change positions to capitalize on market gains.

"[O]ne has to be careful in arguing a point using simple data that just supports a view without trying to disprove the idea with more intensive and insightful analysis," he wrote. "In this context, markets can move up another 10-12% in our view for 2011, but the trajectory is likely to be quite uneven with potentially sharp moves in either direction requiring a nimble trading orientation rather than an easy buy and hold strategy."