by Bryan Rich

According to the financial markets, the world has become a very calm and comfortable place again. But has it?

Just a year ago markets were crashing all around us

The U.S. housing market had started the snowball rolling far earlier. Then the U.S. stock market finally turned over. Later, other markets, like commodities and currencies, woke up to the realization that a crisis in the U.S. economy had tentacles reaching around the world! And the music stopped

Investors went running for the exits, markets collapsed and U.S. Treasuries and the U.S. dollar soared as capital around the world fled to safety. The theory of global diversification crumbled. And the risk gauge for financial markets skyrocketed.

A good pulse of the markets assessment of risk shows up in implied volatility. Heres a brief explanation of what Im talking about:

Actual volatility is the dispersion of prices around the mean — simply a markets price volatility. On the other hand, implied volatility is determined by market participants. Its the perception of how volatile the markets will be and how certain (or uncertain) the outcomes will be.

This makes implied volatility a good risk barometer. And thats why its a key component in pricing options, where market participants typically go for protection when the perception of risk in the financial markets rises.

So what was the market saying about risk this time last year? Heres a look at a chart on implied volatility in the Australian dollar and the S&P 500

As you can see, the massive surge beginning last September was nearly a five-fold jump in the fear gauge — a clear panic in financial markets.

And the trigger was

First, a huge third-quarter loss from Lehman Brothers and a downgraded estimate for Merrill Lynch.

Then, a weekend takeover of Merrill Lynch by Bank of America.

And finally, the announcement of Lehman Brothers bankruptcy.

But heres the thing

Wall Street Has Proven to Be

Lousy At Estimating Risk

Just prior to the September 2008 spike in volatility, Wall Streets mood was pretty rosy, despite the trail of disaster that had already been delivered:

Morgan Stanley lowered expectations for global growth from 5 percent to between 3.5 percent and 4 percent. Global growth went negative.

Lehman Brothers said they expected stocks to climb at least 17 percent by December 31. Eight days later Lehman Brothers was bankrupt.

Citibank said they expected 2008 to mark the biggest year-end rally in stocks in a decade.

And JP Morgan was looking for an 11 percent rally into the year end.

Stocks never made a tick higher and finished the year down another 29 percent.

This is a good example of how complacency and unwarranted optimism can end abruptly. And I think thats what were going to see again.

Since the middle of last year, financial markets have traded distinctly in one of two camps: Either risky or safe. When volatility was soaring, global investors fled all things risky for a safe place to park their capital. The dollar benefited and so did U.S. Treasury prices.

But since March of this year, triggered by the Fed Chairmans finding of green shoots in the economy, this risk aversion trade has reversed. Capital has steadily and aggressively moved out of safety and into riskier, higher-return investments.

Will we see another spike in fear when a negative surprise hits the markets? I think we will. And I think the setback for the global economy will be considerable

Investor and consumer confidence, when burned again, will be very difficult to regain. And that creates a scenario for prolonged weakness in economies and prolonged weakness in financial markets.

Market Position Signals

Risk Appetite Is Vulnerable

The Australian dollar has been the high-beta trade among major currencies in this run-up in risky assets. In other words, the Australian dollar has gained nearly 2 percent for every 1 percent in the euro or the British pound.

And as you can see in the chart below, it has gained more in percentage terms than it lost at the height of fear in the global economy. Even the optimists have to agree, things arent that good today!

Technically speaking, the currency is also running up against an important retracement level.

And more investors have gone long the Australian dollar than at any time since July of last year — which by no coincidence was the same time the currency reached its highs and turned sharply lower.

So be very cautious of this run-up in risk appetite. Based on the action in the Australian dollar, and considering the markets vulnerability to another dose of fear, the dollar and the risk aversion trade look more likely to return.

Regards,

Bryan

www.moneyandmarkets.com.

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