Guest Post: What Could Possibly Go Wrong?

Via John Aziz of Azizonomics blog,

Uber-bullishness is the order of the day in the markets. Last week we noted that the DJIA has climbed to a new post-2007 high. And now, the “fear index” VIX is hitting lows (as we discussed in depth last night):

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Popular commentators like Bill McBride are declaring the era of crisis to be almost over:

It looks like economic growth will pickup over the next few years. I’ve written about this before – a combination of growth in the key housing sector, a significant amount of household deleveraging behind us, the end of the drag from state and local government layoffs (four years of austerity nearing the end), some loosening of household credit, and the Fed staying accommodative (with a 7.8% unemployment rate and inflation below the Fed’s target, the Fed will remain accommodative).

While there has been recovery in metrics like industrial production, durable goods orders and GDP, the (artificially stimulated) euphoria in markets is probably strange news to consumers and workers and businesses and job seekers in the real economy. All the various measures of unemployment remain weak especially the employment-population ratio which is still deeply depressed. Private-sector debt remains dangerously high. Home prices are still depressed and foreclosures remain high. Consumer sentiment remains depressed. The financial sector continues to blunder from disaster to disaster. And there are lots of big geopolitical dangers still on the table — not least Japan-China and Iran-Israel.

This implies that the market has become dangerously euphoric, and that risk is being improperly priced.

The last time VIX fell to an all-time low and market-confidence hit an all-time high, it presaged a financial crisis. John Stoltzfus of Oppenheimer Asset Management writes:

We caution our readers about past periods of deflated volatility; the last time the VIX traded down to a new low, which occurred on 01/24/07, it rallied drastically in the following month. Approximately six weeks later on 03/05/07 the index had increased to 98.48%. By 08/16/07, less than eight months from the low, the VIX index was up 211.73%.

This time may not be so different.