Market calm hides growing concern

As a parent of three young children, I know that something's not right when an eerie quiet falls over the house. Normally, it involves glue, markers, candy or a combination of the three. And hair! Always in the hair.

Something similar could be said of the state of the stock market right now. The Standard & Poor's 500 hasn't suffered a 10 percent correction in more than 1,000 days, defying everything from renewed financial concerns in the eurozone, to the outbreak of new violence in the Middle East, to the Cold War-like standoff with Russia.

The equally placid Dow Jones industrial average hasn't seen its 200-day moving average since February, its 50-day average since May or closed below its 20-day average since June. And while there have been longer runs of quiet in market history, such as the period between 2003 and 2007, that surface tranquility may be masking deeper dangers.

For one, corporate valuations have exceeded current levels only in the midst of late-stage bubbles in 1929, 2000 and 2007. There is also evidence of investor complacency with a "dash for trash" in recent weeks, as the most shorted stocks in the market lead the way higher. And we continue to see the computer trading algorithms dominate the tape, as evidenced by the tight connection between stocks and carry trade currencies like the Japanese yen and the Australian dollar.

Market insiders also appear to be preparing for trouble given the rise in the S&P 500 SKEW indicator to record highs relative to current volatility. This measures how much option traders are willing to pay up, with real money, to protect against or profit from a dramatic decline in share prices. This suggests real worry behind the scenes.

We can see similar "risk-off " behavior in the way small-cap stocks have been underperforming. Or in the selling pressure that's been hitting high-yield corporate bonds. Or in the way market breadth has been narrowing.

No one knows what catalyst might finally cause investors to snap out of their fever dream. Maybe it'll be the real risk that Portugal's banking troubles result in a contagion effect that rattles European debt market. Maybe the situation in Iraq or Israel will take a turn for the worse.

All I know is that the market is more than fully priced; that the Federal Reserve is preparing to end the massive bond purchases that have propelled the stock market for five years; that investor sentiment is off the charts; that insiders are preparing for the worst; and that fewer and fewer stocks are participating to the upside.

We've got another Fed policy announcement next Wednesday in which it will surely continue to withdraw stimulus, setting the stage for the program to end in October. The U.S. Commerce Department next week will also release its initial estimate for U.S. economic growth in the April-to-June period. Both of these could rattle markets.

And of course, it's worth remembering that the last major bout of market volatility was driven by the political realm. Specifically, the battle between the GOP-led House and the Obama administration over the budget that led, ultimately, to the loss of America's AAA credit rating from Standard & Poor's in August 2011. Right now, the GOP has a very real chance of taking the Senate this November, an outcome that could bring back some bad memories for investors.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.