IT'S THAT TIME

again. The time for fearless market predictions for the coming year.

My fearless prediction is that the year will be anything but fearless. Markets can never maintain extremes for long, and for some time now we've been at an extreme of fearlessness. It's time to get back to normal, and for markets to scare investors like they usually do.

Why do I say markets are excessively fearless?

Look at stocks. The VIX index measures investor sentiment about the volatility of the stock market, by measuring the premiums in the prices of index options. For the last several months this index has been hovering in the neighborhood of all-time lows.

That means that investors don't expect stock prices to move very violently one way or the other. They don't expect any kind of big news to impact stocks one way or the other. They see little risk. They are fearless.

Look at Treasury bonds. Everyone knows that long-term bonds are riskier than short-term bonds. That's why long-term yields are almost always higher than short-term yields because investors need to be compensated for extra risk. Yet, today, long-term yields are lower than short-term yields it's the so-called "inverted yield curve."

Look at junk bonds bonds issued by companies that aren't very creditworthy. Normally the yield of junk bonds is far higher than the yield of investment-grade bonds, the bonds issued by the biggest and strongest companies. Today junk commands only about a 3% higher yield than investment-grade. That's about the smallest yield spread in history.

And I also sense fearlessness when I talk to my investor clients, and when I read what market pundits say on TV and in the press. Sure, there are plenty of doom-and-gloomsters out there predicting Armageddon there always are. But mostly I find people talking about how 2007 is going to be a "Goldilocks economy," where we have reasonably strong economic growth, full employment, and no inflation.

Yeah, right. And fried chicken will fly into your mouth, too.

Sorry, it's just not going to be this easy. It never is.

Why? Because the world is a dynamic and volatile place, and the only constant is change. When things change even when they change for the better there are always winners and losers. There is always risk.

The way investors cope with risk is by making sure that their investments are properly priced so that they have a cushion when things go wrong, as they always do. It's easy to see that principle at work in junk bonds. Uncreditworthy bond issuers have a greater chance of going bankrupt. That's no problem if you collect a big enough yield across your whole junk portfolio to make up for the few losers, but even just a few losers can kill you if you haven't been collecting enough yield to make up for it.

Think about it in terms of stocks. You get lulled into a false sense of complacency by the gently, nonvolatile pattern of trading we've gotten used to the pattern reflected in the record-low VIX. You start telling yourself, "Hey, stocks aren't risky at all. Instead of putting 50% of my money in stocks, I'll put in 100%. In fact, I'll use margin and go to 200%. Why not?"

The reason why not is that sooner or later probably sooner something will happen, and at least for a while stocks will become volatile again. As soon as that happens, you're in trouble because you've got 200% of your money in stocks, but you're the kind of guy who only has a 50% stomach. Instead of losing 50 cents, you'll lose two dollars...and you'll panic. You'll sell right at the bottom. Happens every time.

All of which begs the question, why are markets so placid now? How come there's so little risk in the world? What has lulled investors into complacency?

It comes back to something I've written about many times in this column. It has happened because interest rates are too low.

What do rates have to do with it? Simple: When rates are low, it's because there's plenty of money to borrow. And when there's plenty of money to borrow and rates are low, you can always get out of any problem.

Think about it. A couple of years ago rates were so low and it was so easy to borrow money, everyone was buying a new house (or maybe two). When the teaser mortgage came due, no problem just borrow more money and get a new teaser mortgage.

That game is over, because rates aren't ultra-low anymore, and lenders aren't so eager to lend into a falling real estate market. Now there's a real issue about how some borrowers are going to refinance, with rates higher, money scarcer, and home-equity levels on the decline.

I'm not saying that the real estate market is what's going to trigger the next big problem in the economy or the markets. I'm just saying that when interest rates go up, things get riskier. Housing was the great beneficiary of low rates, and it's been the first victim as rates have gotten closer to normal.

Rates are headed higher. And as they rise, the world will get riskier and riskier. Here's a possible scenario. Someday probably sooner than later some hedge fund somewhere will blow up.

If it had happened a year ago like when the Amaranth Fund blew up last spring, when rates were lower there would be no problem. But this time rates will be higher, it won't be so easy to bail out the fund and the banks and brokers that lent to it. No bail-out, and you get panic selling. And when you have panic selling, that causes another hedge fund to blow up and so on, and so on.

I get worried when I see things like the way oil and some commodities have fallen this week. Somewhere in the world some hedge fund lost billions on that. One of these days, that kind of thing will trigger a real problem.

Don't get me wrong. I'm not forecasting gloom and doom. I'm forecasting normality. I'm forecasting a normal world in which there is real risk for investors, and investors get paid to take that risk.

But based on today's excessive fearlessness, a little bit of normality might come as a shock.

In other words, right now we have nothing to fear but fearlessness itself.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at

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