Amid Rising Stock Market Uncertainty, Equities Must Price in Risk

The U.S. stock market is coming off a week of historical highs with the Dow Jones Industrial Average, Nasdaq Composite and S&P 500 all hitting record highs.

Corporate earnings supporting these historical highs are up by 4.2% year over year, showing a second quarterly increase after five quarters of negative growth.

The S&P 500 is about 21 times the earnings received in the past 12 months and is higher than its 10-year average, which comes in at about 16.

Yale University Professor Robert Shiller's CAPE ratio stands at 28.46. The historical average of this measure is about 18.

And an increasing CAPE has only been this high twice before, once on its ascent to the level it reached before the stock market crash in 1929 and the second time during its increase to the 2000 market peak.

A look at the Chicago Board Options Exchange's measure of market volatility, the VIX, shows that volatility is quite low. In fact, the VIX measure is the lowest it has been since 2014.

Furthermore, the VIX is below all but 1% of readings in its history.

"From the Friday before the presidential election through Friday's close, the fear gauge has had its sharpest 12-week drop ever," according to Charlie Biletto, director of research at Pension Partners.

But this tells us something that is very relevant for the times.

"The problem with the VIX ... is that it is backward looking and tends to fall during periods of rising stock prices such as the recent Trump rally. Over its history, stocks have done poorly in the year following very low VIX levels," according to Biletto.

Is this something of which stock investors should take note?

Yes, but this information should also be looked at in association with some other indicators of what we might expect.

These indicators come from the first week of the president's actions that have garnered headlines such as one in The Wall Street Journal Monday, "Donald Trump's Immigration Ban Sow Chaos."

Then there were the front page headlines about the battle between Trump and Enrique Pena Nieto, the president of Mexico, America's third-largest trading partner.

There been many other headlines about Trump during his very turbulent first week and a half in office.

This seems to be the way this administration is going to conduct business.

As House Speaker Paul Ryan said, "This is a very unconventional president."

The implication is that uncertainty will be a factor in the financial markets during this administration and the uncertainty might grow.

Greater uncertainty means greater risk. And greater risk must get priced into the markets.

The aforementioned Wall Street Journal article closes with the thought: "A low VIX isn't in and of itself worrisome, but the 'calm before the storm' idea has some basis in history. Some of the lowest historical VIX readings preceded sharp, unexpected stock sell-offs such as the 2008 financial crisis and the 1994 interest rate scare."

Add to all this the possibility that a new, untested president with a problematic temperament might add even more uncertainty, making a real case for being wary about where the stock market might go over the next six months or so.

This possibility is a major reason for being very cautious these days, particularly given the fact that the stock market has been trading at historic highs. Unpredictability doesn't add value to over-valued prices.

This article is commentary by an independent contributor. 

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