The global equity market faces a number of risks and the risks I worry about most are those that aren’t completely reflected in relevant asset prices. In other words, if these scenarios [were to] occur, investors…[wouldn’t be] compensated for any resulting violent market reaction. Here’s a look at four such risks.
So writes Russ Koesterich (http://isharesblog.com/blog/) in edited excerpts from his original article* entitled 4 Market Risks Worth Worrying About.
[The following article is presented by Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com and www.munKNEE.com and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Koesterich goes on to say in further edited excerpts:
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.
[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
*http://isharesblog.com/blog/2013/05/23/4-market-risks-worth-worrying-about/ (Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog; ©2010-2012 BlackRock. All rights reserved.)