Morgan Stanley: "People Have A Hard Time Even Imagining How The Market Could Decline"

A calm complacency never before seen has fallen blanket-like over US equity markets.

"The behavior of volatility has entirely changed since 2014," noted BAML in a a recent note thanks to major central banks keeping interest rates near historic lows (and printed more money than ever before).

As The Wall Street Journal points out, One sign of that: VIX closed below 10 more times last year than any others year in its history, and until today, closed below 10 for the first 5 days of 2018...

 

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And while correlation is not causation, there is a clear causal link between the conditioning now deeply embedded within investors' minds and the endless expansion of central bank balance sheets...

 

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As JPMorgan's infamous quant guru Marko Kolanovic wrote, "the first four Fed hikes in a decade have failed to generate the revival of volatilities that many had expected at the end of last year," and a wave of political uncertainty linked to U.S. tensions with North Korea and the new presidential administration also raised the prospect that market tumults could occur with greater frequency... but no...

In fact worse still for The Fed, financial conditions eased as they tightened and vol collapsed to levels never seen before...

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All of which has led, as The Wall Street Journal reports, to a number of investors abandoning defensive positions taken to protect against a market downturn, in the latest sign that many doubters are shedding caution as the long rally rolls on.

“I haven’t seen hedging activity this light since the end of the financial crisis,” said Peter Cecchini, a New York-based chief market strategist at Cantor Fitzgerald.

“It started in late 2016 and accelerated in the second half of the year.”

But as Morgan Stanley warns in a recent note, what goes up (this fast) typically comes down...

"Our team has observed a dramatic shift in sentiment since we initiated coverage in April. In April, it felt as if people were looking for a reason for the market to fail.

Now, we have seen a total reversal with people having a hard time even imagining how the market could decline."

The rapid rise in sentiment indicators and speculative behavior we have seen gives MS more conviction that we are due for a minor correction in the short term.

According to the American Association of Individual Investors (AAII) survey, which asks individual investors what direction they think the stock market will be in the next 6 months, nearly 60% of investors are bullish. This is the highest percentage of bullish responses recorded by the survey since 2010...

 

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The ratio of the percent of investors who respond as bullish to those who respond as bearish has also been rising to near record high levels - there are now 3.8 times as many bulls as there are bears...

 

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And as we noted previously, the monthly relative strength index (RSI) for the S&P 500 indicates that the market is the most overbought it has been in over 20 years. The RSI is currently at the second highest level it has reached since 1928, a whopping 93.

 

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In the past, when the RSI has peaked above 80 an average correction of -3.5% has followed one month later. The corrections have ranged from -0.8% to -7.7%.

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Morgan Stanley concludes, a pull back feels close and it is now just a matter of time...

And there's plenty of ammunition to fuel the downside.

Managers are increasingly positioning themselves to capture more potential upside not wanting to miss out in market that keeps rising. At the same time, gross leverage has also declined modestly - managers are removing shorts but not putting that money into more long positions.

However, gross leverage remains close to a 12 year high. An increase in volatility will likely lead to a forced reduction.

 

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Of course, by letting their hedges expire as we noted above, investors would feel the full brunt of a market selloff. While that would intensify the pain for any individual trader, some analysts and brokers worry that the cumulative effect of more investors giving up their protective positions could itself become a source of volatility.

Many investors could rush to sell their positions and limit their losses during the next period of market weakness, exacerbating any plunge in prices.

“When the ultimate disruption occurs, the market is less prepared for it,” Dean Curnutt, chief executive at New York brokerage Macro Risk Advisors, said.

“That becomes an amplifier of the risk.”

But that won't be allowed to happen, right? Because "it's different this time."

Though, as a reminder, TINA's dead...

 

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Bonds are now an 'alternative'