Are You Keeping Up With This "Risk-On" Market?

Are You Keeping Up With This "Risk-On" Market?

Stocks were up for a fourth consecutive day, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average gaining 0.7% and 0.5%, respectively.

Consistent with those gains, the CBOE Volatility Index (VIX) , Wall Street's "fear index," fell nearly 3% to close at 14.35, its lowest closing level since May 24. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Fear is out, risk is back in
Last month's stock market volatility is nearly forgotten, a small bump on the road to higher equity prices. This has important implications for contrarian investors, so let's look at the facts:

  • The S&P 500 is back to within 1% of its all-time nominal high, achieved on May 21. The cyclically adjusted price-to-earnings ratio of the index, which uses the 10-year average of inflation-adjusted earnings-per-share, is 23.8, or 44% above the ratio's historical average going back to 1881.

Inveterate bulls will respond that ultra-low interest rates render the comparison to a historical average moot; however, in the 22-year period spanning 1934 through 1955, during which the 10-year Treasury yield remained below 3%, the CAPE never got as high as it is today.

  • The Russell 2000 Index of small-capitalization stocks closed at a record high today. The price-to-earnings ratio of the index now stands at approximately 20 (excluding negative earnings). Small-capitalization stocks, which are inherently riskier than their large-cap cousins, are a good indicator of risk appetite.

  • Notwithstanding last month's market hiccups, volatility remains very low by historical standards. That may not be obvious because we have become accustomed to low volatility. The VIX Index, which I mentioned above, is currently in line with its year-to-date average (14.26) and only a bit below its average over the past twelve months (15.32). However, it's almost 30% below its average going back to the inception of the index in Jan. 1990 (20.31). In fact, today's closing value is in the lowest quartile of the historical series.

  • So-called "safe haven" assets such as Treasury bonds and gold have performed dreadfully this year.

In light of these observations, should conscientious contrarians sell all risk assets from their portfolios? Certainly not; however, in this environment, savvy investors will know to remain highly focused on valuation and alert for pockets of cheapness as they pop up. Emerging markets, which have struggled recently, are one area of the investment landscape to keep an eye on.

Alternatively, with many global regions still stuck in neutral, their resurgence could result in windfall profits for select U.S. companies. Our recent report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!

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Fool contributor Alex Dumortier, CFA, has no position in any stocks mentioned; you can follow him on LinkedIn. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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