Volatility is extremely low and stocks have relentlessly rallied. The rally has not been even among the indices with the Nasdaq outperforming and the Russell 2000 lagging. The Nasdaq is up 12.65% year to date even after being down Wednesday partially because of Apple’s earnings disappointment. The Russell 2000 is only up 2.39% and underperformed Wednesday even though it wasn’t effected by Apple’s weakness. The divergence of these two indices tells us the repatriation tax holiday is more likely to pass than regulatory reform. The Nasdaq is greatly affected by the big five technology firms which are Amazon (AMZN), Microsoft (MSFT), Apple (AAPL), Google (GOOGL), and Facebook (FB). They mostly have large cash hoards overseas which means they’ll benefit from the repatriation holiday. The KRE small bank ETF shows the hype surrounding the repeal of Dodd-Frank has subdued as the index is down over 8% from its highs and is down 1.43% year to date.

As I mentioned volatility has been very low. The VIX was below the 11 handle again on Wednesday. The first four months of the year saw the lowest volatility in 20 years. The standard deviation of the S&P 500 was 0.4% which translates to a VIX of 8. That means the VIX being at a 10 handle overestimates the past volatility in the market. This may be caused by investors fretting about how high stocks have moved. We’ve had a few days this year where the VIX rallied along with the S&P 500. As you can see from the chart below, in this period of low volatility there hasn’t been a day where stocks fell 1.5% or more. It has been 160 days since the last 1.5% decline which is well over the average of 22 days.

The realized volatility might be getting suppressed by the recent popularity in exchange trade products based off the VIX. The VIX exchange traded products have absorbed $700 million in investments this year. Most of these investments go into the VXX which acts as the inverse to the VIX. In other words, it’s a derivative bullish bet on the S&P 500. The two worries about the popularity of these products is that they suppress volatility, but when the tide turns they can increase volatility.

I see this as like mortgage backed securities in the housing market. It seems like whenever there’s a trend which has been going on for a while, derivatives markets perk up to make more money on this asset which supposedly will always rises in value. People said housing prices would never fall before the housing crisis and now people are saying the same thing about stocks. The narrative is stocks always rise over time. The chart below shows the proliferation of investments in the VXX. The economy has become financialized. It won’t look pretty when that white line moves lower. As you can see, the ETP market for the VIX barley existed in 2008 during the financial crisis. Investing in the VXX was a great call in 2009 when it first came out, but now it’s too popular and the market is too expensive.

The economy has become financialized because real growth isn’t available anymore. 0.7% GDP growth doesn’t support a ‘risk on’ strategy, so something must be done to satiate the greed on Wall Street. Speaking of the financialization of the economy, on Tuesday, a new set of leveraged ETFs were approved by the SEC. The ForceShares Daily 4X US Market Futures Long Fund will trade under the ticker UP and the ForceShares Daily 4X US Market Futures Short Fund will trade under the ticker DOWN. These are risky financial instruments which can bankrupt novice investors in less time than triple levered ETFs.

Don’t confuse my concern about these new ETFs with having the perspective that these new ETFs shouldn’t be allowed. I think they should be allowed, but they act as a warning sign that the environment has gotten too good. You don’t hear about Uber drivers buying stocks and new instruments that add leverage when the market is headed down. It’s true that the DOWN ETF is profitable when the market falls. However, when stocks fall, money will flow out of the market in general. There won’t be a need to hedge with short funds because they’ll be less long funds. We are truly in a ‘risk on’ environment where investors have decided that being long an extremely expensive stock market is not risky enough!

The bubble has a toxic mixture of speculators picking up quarters in front of train in the form of piling into the VXX and passive investors who mindlessly buy index funds without bothering to check valuations. Vanguard took in over $25 billion to its index funds in April which is the highest take for a month ever. The total take for the year is now over $145 billion which makes the pace for the year $437 billion which is shown in the chart below. As you can see, the flows from retail investors have more than made up for the declines in buybacks. The bullishness from retail investors based on no analysis is pushing stocks higher. They think stocks always go up over time because the market rallied after the crash in 2009. However, that’s not a rule. Stocks rallied because of quantitative easing and low interest rates. When they crash again, they aren’t guaranteed to have great returns afterwards. There is no free lunch in investing.

Conclusion

The stock market’s low volatility is disconcerting because stocks are expensive and economic growth is weak. The rally was powered by buybacks and quantitative easing early on, but now it’s being pushed up by retail investors to insure the maximum pain when the house of cards eventually falls. The flows into Vanguard ETFs is on a run rate which is over four times as large as the level of investment in 2009. Clearly retail investors are terrible at timing the market. I was wrong in my bearishness early last year as I didn’t see retail investors becoming this optimistic because of Trump’s election. At that point, it wasn’t clear who would be the GOP and Democrat nominee for president. The economy staved off a recession due to global central bank action early in 2016 and rode some of the tailwinds provided by optimism after the election.