The risk of an unknown exogenous shock – The market seems too complacent. This is perhaps the scariest risk. There’s very little you can do to actually prepare for such exogenous shocks because they’re impossible to predict. There’s always the chance that North Korea is going to do something unpredictable. There’s always the chance that we’re going to see another tragedy like Boston.
Sometimes terrible things happen, and it’s not exactly clear when they’re going to happen. So you just have to think: Is the market priced for perfection? Is there some cushion in prices if an exogenous event occurs out of the blue? How complacent, or how nervous, are investors?
One measure for this is the VIX or CBOE Volatility Index (otherwise known as the fear gauge). The index tracks the implied volatility in S&P 500 options. Low levels suggest that investors are feeling sufficiently confident that they’re not paying much of a premium to buy insurance – in the form of put options – on the market. In other words, they don’t believe that markets will move much up or down, meaning there’s not likely to be a lot of bad news. On the other hand, when the VIX is high, investors are paying a bigger premium and they’re nervous.
The index is currently at 14, well below both the long-term average of around 20 and the average seen between 2008 and 2012. Even with global markets’ drop, investors still appear complacent, and I believe a modest exogenous shock may lead to an outsized correction.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.