All's Quiet in the Stock Market, Maybe Too Quiet

Last Updated Jan 17, 2010 4:31 PM EST

The last few months have been one of the calmest periods ever for the stock market. The cyclical nature of the market - reaching an extreme and then undergoing a reversal proportionate to the preceding move, like a financial Newton's Third Law of Motion - means that the next storm is almost certain to be violent.

If you want evidence that trading has been remarkably placid, look at a chart of the Standard & Poor's 500-stock index. It has continued to reach new recovery highs with ever diminishing pullbacks but also with increasingly meager rallies. Together they produce a narrower trading range and a pronounced slowing of the pace of the advance.

If you don't trust your eyeballs, consider the message contained in the CBOE Volatility Index, which uses the pricing of stock index options to calculate the level of market volatility anticipated over the next month. The VIX, as it is commonly known, has experienced its most precipitous fall ever, from nearly 90 after the Lehman Brothers failure in 2008 to less than 17 this week.

Any reading below 20 indicates that investors believe volatility will remain low, and it often presages a correction or worse. Connecting the dots between investors' mindset and their trading explains why.

Investors who believe that potential declines are limited in scope become complacent about risk. They are more inclined to be fully invested but also more capable of being surprised when the market suffers more than a minimal fall.

Another widely acknowledged sign of complacency, an extremely low proportion of bears in the weekly Investors Intelligence survey of investment newsletter editors, also tends to herald a market decline for the same reason. Guess what: That indicator is flashing an even more ominous warning than the VIX.

The survey recently showed 15 percent bears, the lowest figure since the spring of 1987, before the top that led almost immediately to the crash that marked the worst day in stock market history. Crashes are so rare that predicting one seems foolish, but are the survey and the VIX foretelling a significant, if more leisurely, decline?

Mary Ann Bartels, a technical analyst at Banc of America Securities-Merrill Lynch, contends that another piece of information in the survey suggests otherwise. She notes in a report this week that the proportion of advisors anticipating a correction, about 45 percent, is very high; this leads her to think that a correction won't happen, at least for a while.

Bartels has a great track record as a forecaster, as noted here and here, so investors bet against her at their peril. Still, there is a plausible - and bearish - explanation for the survey's conflicting signals: When combined with the low proportion of bears, the high expectation of a correction may indicate an ingrained buy-the-dip mentality, as if advisors are confident that there will be a correction, but nothing more serious.

The markets have a way of confounding the expectations of the greatest number of investors. A big decline would wrong-foot both the bulls and those in the correction camp and prove the dwindling number of bears right. That unexpected outcome seems the most likely.