"What worries you the most?" "What keeps you up at night?" I get these questions a lot from investors looking for insight into what might cause the next market correction. These questions are even more in focus now, given the drop in global markets that we witnessed on Thursday.
As I've said before, the global equity market faces a number of risks. However, the risks I worry about most are those that aren't completely reflected in relevant asset prices. In other words, if these scenarios occur, investors aren't being compensated for any resulting violent market reaction. Here's a look at four such risks.
1. The risk of a U.S. slowdown -- not discounted in U.S. valuations. While U.S. valuations currently look reasonable, they're predicated on a U.S. economy growing at around 2% to 2.5%. The risk of slower growth is not priced into the market. If U.S. economic data continues to disappoint, and we get a growth hiccup in the second or third quarter, then we're likely to see some U.S. market weakness.
2. The risk of a crisis in the Middle East -- not fully discounted in oil prices. Oil is currently trading a little higher than I would expect given the current supply situation and inventory levels. This suggests that a bit of risk premium is built into oil prices. However, prices aren't high enough to discount potential large events related to a Middle East crisis. As a result, in a scenario such as an Iranian production shutdown, oil prices would likely spike.
3. The risk of a eurozone crisis flare-up -- not fully discounted in eurozone valuations. Many people are worried about a European banking crisis or the euro dissolving, so eurozone stock prices already reflect a fair amount of risk. But prices in the region still could be cheaper.
4. 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.