The Only Thing Investors Have to Fear Is Fearlessness Itself

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?"