Where Has the (Perception of) Risk Gone?

We have pointed out various signs of complacency in financial markets regarding risk: declining credit spreads (January 16), a lack of concern about systemically high use of leverage (previous post plus January 18), and technical indications that suggest we are near a stock market peak (January 22). Yet there is an almost irrationally high level of optimism, despite the poor prospects for the Middle East and the uncertainty regarding the future direction of oil prices.

Here are a few more benchmarks:

The VIX was trading at historically low levels. The VIX is the CBOE’s volatility index, based on S&P 500 index options and is considered to be a good indicator of stock market risk over the contract life (30 days). Some institutional investors were worried last November when it reached a 12 year low of 9.90 (its average over the preceeding 10 years was 20.96. It closed at 9.89 on January 24, a new low, but rose to 11.23 on January 25, so perhaps the excessive enthusiasm has already corrected itself. But even 11 is an awfully optimistic level for this instrument.

According to a January 24 Bloomberg story:

The risk of owning European corporate bonds dropped to a record today, according to credit-default swap traders. The amount of debt used to finance European buyouts rose to 8.7 times earnings in the third quarter, the most ever, and the Dow Jones Industrial Average this month rose to a record….For now, corporate chieftains are the most confident in at least a decade as more than 2,500 business leaders gathered in Davos, according to the PricewaterhouseCoopers LLP survey published today. Ninety-two percent of 1,084 executives questioned said they are “confident” or “very confident” about their prospects this year. That’s the highest reading since the firm introduced the survey 10 years ago.

A warning from last year’s World Economic Forum may apply now. The then Harvard President Larry Summers took a dim view of the complacency about global imbalances. As reported in the Financial Times:

Commenting on the general lack of concern at the World Economic Forum about the soaring US trade, Mr Summers recalled the sense of calm that existed before the Mexcian crisis in 1994 and the bursting of the technology bubble in 2000. “The time of greatest serenity was also the time of greatest risk”.

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