The Stock Market Is Calm. You're Warned

If you've been checking your portfolio regularly, you may have noticed something peculiar: Week after week, the market has been moving up without major setbacks. The Standard & Poor's 500-stock index soared 30 percent from July 2 to Feb. 15, falling 1 percent or more on only 13 occasions during that time. Based on one measure of volatility, stocks haven't risen this much amid price swings this narrow since 1971.

Don't get complacent. While many investors expect the rally to continue, analysts say the calm can't last and may be a sign of a coming pullback. "It is unusual to have such a slow grind higher," says Walter Todd, who helps manage about $900 million at Greenwood Capital Associates in Greenwood, S.C.

The Federal Reserve's $600 billion program of buying Treasuries has boosted confidence in the U.S. economy, which grew more rapidly in the fourth quarter. The decline in volatility that has accompanied the good news puts equities at risk for short-term losses should events challenge investors' optimism.

The S&P 500 had its biggest drop in more than five months on Jan. 28, falling 1.8 percent, as protests in Egypt intensified. While the market bounced back quickly, overseas political uprisings might cause the U.S. gauge to decline again, says Scott O'Neil, a money manager with O'Neil Data Systems and president of MarketSmith, a research firm based in Los Angeles. Stocks could also falter should central banks in developing nations keep raising rates to curb inflation, says Quincy Krosby, chief market strategist for Prudential Financial (PRU).

The benchmark index for U.S. stocks has climbed as companies from Apple (AAPL) to United Parcel Service (UPS) posted fourth-quarter profits that exceeded analysts' estimates. More U.S. companies are surpassing sales forecasts than at any time in at least four years, according to data compiled by Bloomberg. Higher-than-estimated revenue combined with falling unemployment and an improvement in manufacturing signal that the economic recovery is picking up.

Money managers also are more bullish on global stocks this month than they have been in a decade, according to a Bank of America (BAC) poll. The survey showed that 67 percent of respondents, who together manage $569 billion, had an "overweight" position on global equities, the highest level since the survey began in April 2001. That compares with 55 percent in January and 40 percent in December.

Too much optimism can be a bad sign for stocks, as a look at volatility statistics shows. The S&P 500's ride upward has been accompanied by a 69 percent drop in an options-market indicator known as 30-day realized volatility, which fell to 9.996 on Feb. 15 from last year's peak of 32.53 on June 10, Bloomberg data show. During the financial crisis, the gauge soared to 82.21 in November 2008, the highest level since the October 1987 stock market crash.

When 30-day volatility slips below 10 and stays there at least three days, the S&P 500 rises 0.3 percent in the next month, on average. That's half the average monthly advance shown in Bloomberg data going back to 1962. The volatility measure slipped to 7.94 in March 1994, and the S&P index dropped 6.1 percent in the next month. Longer-term, though, the market recovers after that kind of volatility decrease. Over the course of a year following a slump in realized volatility to 10 or lower, the stock index rises 9.2 percent, vs. the 7.4 percent average, Bloomberg data show.

A short-term drop in the market might actually help spur gains over the long haul, says Prudential's Krosby. "Without a pullback, investors are going to be leery of going in because they suspect it will drop," she says. "You want to see a pullback, and it'll be healthy because it can allow the market to move up in a more meaningful way."

David Kelly, who helps oversee $450 billion as chief market strategist at JPMorgan Funds, says the lack of volatility may encourage investors to put more money into the market, which is what they should do. "Stocks are cheap," he says, "and for most long-term investors, the thing they would do is bet on the tide rather than play the waves."

The bottom line: The low level of volatility the market has seen recently has often heralded periods of subpar returns.

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