The two signs warning you to sell UK and US stocks

For the first time in a while, checking the value of my FTSE 100 tracker fund has not been a depressing experience: the index is now sitting around the 6,200 mark, a full 1,000 points, or about 20%, above its 52-week low. Meanwhile, in America, the S&P 500 is not far off its all-time high.

Despite the wobbly economic backdrop, investors seem determined to think positive about the future. But it’s often just when investors are cheeriest that you should be most nervous. Here are two warning signs that we may be heading for a correction.

The fear gauge is very low

Markets are quiet – too quiet, as some might say. “Volatility is at its lowest reading since June 2007, the month that a pair of Bear Sterns hedge funds blew up, sending shock waves across Wall Street,” notes Roben Farzad on Businessweek.com. But what is volatility and how do you measure it? One popular method is via the Chicago Board of Trade’s (CBOT’s) volatility index, or ‘fear gauge’ – the Vix (see below).

The lower the reading – broadly speaking – the less fear investors are feeling. The 30 mark has historically signalled trouble, and it spiked above 80 in November 2008. The long-term average is 17. Where is it now? It recently hit just 13.2. In short, the Vix suggests most investors are relaxed about the possibility of a sharp stockmarket move. That’s enough to make a contrarian investor nervous.

Investors are suspiciously happy

Investors’ timing is generally awful – they buy high, and sell low. Harvard behavioural economists Robin Greenwood and Andrei Shleifer recently looked at five key surveys of investor sentiment, including surveys taking the views of chief financial officers and professional investors.

These surveys ask how bullish or bearish an investor is feeling. Their conclusion is stark: when investors feel confident, they pile more money into shares, expecting the good times to continue. When they are feeling down, they don’t. As economist Gavyn Davies puts it in the Financial Times, investors “chase rising stock prices and vice versa”.

This is exactly the opposite of what they should be doing to make decent long-term returns. The bad news is that right now bullishness abounds. For example, according to Morningstar, fund managers entered 2013 “brimming with optimism” and have invested four times the amount in stocks they did a year ago. They are even “overweight” banking stocks for the first time since 2007.

Meanwhile, borrowing at hedge funds has hit the highest level to start any year since at least 2004, according to Morgan Stanley figures, reports Farzad. And at the New York Stock Exchange, margin debt among member firms rose in November to the highest level since February 2008. In short, there’s plenty of evidence that investors may be getting ahead of themselves.

What to do

For those familiar with spread-betting risks, it is possible to bet on the direction of the Vix with a firm such as IG Index. If you bet, say, £100 per point on the Vix rising, and it moves back to its long-term average of 17, you’d make around £400 ((17-13) x £100). Do remember that you can lose money in the same way if the Vix falls further.

For anyone else, the key message is twofold: if you’ve invested and made any short-term gains on cyclical shares such as banks and miners since last autumn, bank them soon. However, if you are thinking of piling into UK or US equities having sat on the sidelines and missed the rally, my advice is simpler – don’t. There are better bargains to be had in unloved Europe.

What is ‘volatility’?

The Chicago Board of Trade Vix index is a widely quoted fear barometer. It captures how worried a particular group of investors – options traders – are about one of the world’s most important indices, the US S&P 500.

Why options? Because an option contract is the only one traded in financial markets that specifically factors risk (volatility) into its price. The mathematical thinking behind them is complex and only of interest to boffins at investment banks. Nonetheless, the basic principles are simple enough and of relevance to all investors.

An S&P 500 option is a bit like an insurance contract for shares. You are insuring against a sudden movement in prices. For example, a ‘put option’ pays out when share prices fall beyond a pre-agreed distance. The holder, or buyer, of such a contract might be a fund manager worried about a temporary fall in share prices that could hit his quarterly performance.

He pays a non-refundable premium to a bank for the right to be compensated should his shares fall in price, just as you might pay a non-refundable premium for the right to claim money from an insurer should someone hit your car.

Here’s the key – the more concerned the bank selling the option is that share prices might fall, the more it will charge. It’s similar to the way car insurers charge dangerous drivers higher premiums. And the higher the price of the option, the higher the Vix index, which collates the information about lots of traded options on the S&P 500 into one number. So does it work as a predictive tool?

If you try to use the Vix to time the market exactly, you’ll be disappointed. But it certainly reacts to trouble – it spiked in 1998 when hedge fund Long Term Capital Management collapsed, and again after the September 11th terrorist attacks, and hit record levels during the credit crunch.

So while you can’t measure the ‘cheapness’ of the Vix as such, it’s pretty safe to say that right now it’s very low, given all the economic risks around stocks.

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