The S&P 500 index hasn’t seen a 5% pullback since June 2016, which ranks as the longest episode without such a correction since 1996. Many market participants are arguing that we are in a period of extreme complacency and that the market is highly vulnerable to earnings disappointments or a tightening in financial conditions. On the other hand, many others are saying that favourable macroeconomic factors, such as accelerating earnings growth, rising profit margins and accommodative monetary policy, are providing support to the recent appreciation of stock prices. Renowned strategist Jim Paulsen many years ago developed a stock market complacency indicator derived from examining market consistency relative to stock volatility. First, this indicator measured market consistency by dividing the number of months with positive stock market returns by the number of months with negative returns over the previous 60 months. The higher the number, meant that the stock market consistently achieved positive performance over the previous five years. Second, stock volatility was measured by looking at the standard deviation of monthly percentage returns in equities over the same five-year time horizon. The lower the number, meant that monthly returns exhibited greater stability.
We decided to update this indicator in order to assess where investor complacency, as defined by this model, currently stands relative to history. As illustrated in the two charts below, since 1950, this indicator historically remained within a range of 0.25 to 0.6. With today’s level exceeding 0.7, one can argue that this indicator currently depicts a historically high degree of market complacency. But most important, history also suggests that there is a high likelihood of a market pullback whenever this complacency ratio reverses from extremely high levels. Indeed, since 1950, negative reversals after this ratio exceeded the 0.6 threshold have a tendency to be followed by equity weakness. An exception occurred in the late '90s, when rising market volatility then coincided with a jump in equity prices until the dot-com bubble finally burst in early 2000.
The bottom line is that investors should cautiously monitor future developments in this market complacency indicator. Its weakening from current levels could add to the list of warning signals for a potential repricing of risk assets.
