Investors Need to Mind This Bizarro Stock Market

Investors Need to Mind This Bizarro Stock Market

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

After a first half of the month that was virtually an interrupted winning streak for U.S. stocks (11 of 12 trading days were winners through September 18), the second half of September is turning into a losing streak. The S&P 500 fell 0.3% today, racking up its fifth consecutive daily loss. The narrower, price-weighted Dow Jones Industrial Average was down 0.4%. Chalk it up as pure randomness or just another manifestation of the bizarro "QE world" that asset markets are stuck in.

"QE" refers to the Fed's quantitative easing program, under which the Fed is purchasing $85 billion a month in government and mortgage bonds in order to spur investor confidence, asset prices, consumption, investment and, ultimately, economic growth and job creation (not to mention curing sciatica). Flippant parentheticals aside, I think the Fed is probably following the right course, but it is apparent that zero interest rates and massive bond buying have created some distortions and odd phenomena in the financial markets.

And speaking of odd phenomena, how to explain that the CBOE Volatility Index was down again today -- albeit by only 0.50%, to close just above 14 -- just one day after Treasury secretary Jack Lew observed of the financial markets that "if you look at the calm out there, it's a bit greater than it should be [in light of the looming federal debt ceiling]"? This was the Treasury secretary speaking - a man with a heavy institutional bias toward reassuring, positive assessments of U.S. financial markets.

The VIX, Wall Street's "fear index," is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days. Typically, the VIX moves in the direction opposite to that of the S&P 500. Essentially, investors associate lower volatility with stock market rallies than stock market crashes (in numerical terms, the lifelong correlation between daily changes in the VIX and those in the S&P 500 are -0.7). However, in four of the past five days, the VIX has moved in the same direction as the S&P 500.

Furthermore, the absolute level of the VIX is confounding. As I wrote just six days ago, with the VIX at 13.16, "I find it scarcely conceivable that investors should sell volatility down to such depressed levels, given that lawmakers are set to butt heads over the federal budget and debt ceiling during [the next 30 days]." In the month that preceded Congress's last-minute "fix" of the previous debt ceiling fiasco, in August 2011, the average closing price of the VIX was 19.62, and our polity doesn't look less dysfunctional now -- rather the opposite.

A VIX at 14 leaves no room for the possibility of a (well-telegraphed) Black Swan like a technical default of the U.S. on its obligations. I'm not saying that I expect this to occur, but, with U.S. stocks fully priced, it seems to me the short-term risk is to the downside. This needn't concern long-term investors, of course, but it's always worth noting when market indicators appear inconsistent with economic -- and political -- reality.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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