Fidelity: Will Goldilocks market have a happy ending?

A Fidelity Investments analyst is warning that a fairy tale stock market may not have a fairy tale ending.

What makes the current stock market such a wonderland? “Investors have enjoyed the best of all worlds,” said Jurrien Timmer, Fidelity’s director of global macro. “They have had very outsized returns for lower-than-average volatility. That’s not normal.”

The Standard & Poor’s 500 stock index has gained 17.9% in the past 12 months, well above the blue-chip index’s average 10.2% average annual return since 1926. Yet the CBOE’s VIX index has fallen from 13.2 to 11.78. (It spiked up briefly to 14.8 just before the November election.)

The markets have had plenty of peculiarities. At 2.38%, the bellwether 10-year Treasury note is higher than it was a year ago, but it’s still below its 2017 high of 2.62%. At 1.9%, inflation remains contained. And normally, Wall Street would be pushing earnings estimates down for the year, because estimates usually start high and drift lower as reality sinks in.

What could go wrong? Mr. Timmer frets about two things: The Fed and China. Let’s start with the Fed. “There’s a disconnect between what the market is expecting the Fed will do and what the Fed is saying that it will do,” Mr. Timmer said. The bond market is pricing in two more Fed rate hikes in the next two years.

If you follow the so-called Fed dot plot, however, the consensus is for one more hike this year, three more next year, and three more in 2019. And that’s in addition to reducing the Fed’s balance sheet, which would also push rates up — and tighten financial conditions generally, Mr. Timmer said. “If the Fed raises rates more than the market thinks it will, will that lead to a policy error down the road? It’s on my radar as something that needs to be watched.”

China will also have to tighten policy after its massive credit boost in the past decade. World economies boomed on China’s spending, but how world markets will react to tightening in China is another question. So far, the government has done well, but soft landings are not easy to manage.

The VIX index often correlates well with measures of financial conditions, such as credit spreads, so the volatility index’s current level isn’t entirely surprising, Mr. Timmer said. Eventually, however, volatility will rise. “It comes down to the law of mean reversion. We know mean reversion always happens, but we don’t know when it starts or from what level.”

Long-term investors shouldn’t sell their stocks, Mr. Timmer said. But investors (and advisers) should be wary in the near term of a market that delivers so much return with so little implied risk.

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