Serious Money:Global stock markets have been on a relentless upward march since the summer months, providing investors with seven consecutive months of positive returns. The recovery in markets since the setback in May and June sees annualised returns rise to 20 per cent since the bull market commenced towards the end of 2002., writes Charlie Fell

Investment strategists expect more of the same for 2007. However, the recent gains have occurred on the back of rising complacency as volatility has dropped to historic lows. Markets are priced for perfection or at least for continued stability and economic growth.

The volatility of global stock market returns has been at historically low levels for most of the past 2½ years and the Chicago Board Options Exchange's Volatility Index, a measure of how much investors will pay to protect against future volatility, is near an all-time low.

Additionally, the magnitude of intraday changes in stock price indices has dropped considerably. Consider that for the Dow Jones Industrial Average, the number of days showing daily price declines of more than 1 per cent has dropped from 73 in 2002 to just 11 over the past year. Daily price drops of more than 2 per cent have dropped to zero in each of the past three years from 24 in 2002.

Indeed, the Dow has not experienced a daily price decline of more than 2 per cent in almost 44 months while the four-year long bull market has not experienced a single setback of 10 per cent or more.

The decline in volatility is also apparent across individual stocks and sectors. Segregating the top-performing 10 per cent of stocks from the worst-performers for the S&P 500 shows that the performance differential has narrowed from 25 to 30 per cent in the late-1990s through 2002 to 10 to 12 per cent in recent years. This has occurred as correlations have increased and valuation dispersion across sectors has dropped to historically low levels.

The decline in volatility is not confined to stock markets. Ten-year Treasury yields have remained within a 75 basis point range throughout 2006, which ranks as the third least volatile bond market since 1970. The Merrill Lynch Option Volatility Estimate, which gauges the volatility of bond prices, is at all-time lows. Corporate bond spreads are also at historically low levels and have remained remarkably stable despite a slowdown in the US economy.

The relative calm in financial markets is predicated on an almost universal belief that the US economy will suffer no more than a soft landing in 2007 and, furthermore, that the Federal Reserve will be in easing mode by mid-year. Indeed, references to a "Goldilocks Economy" - one which is neither hot nor too cold, in American newspapers, has set an all-time high while futures markets are priced for a rate cut by the summer.

Simultaneously, the percentage of investment newsletters that are bullish has recently increased to the highest levels in more than a year. Wall Street strategists are similarly enthusiastic with most expecting the S&P 500 to exceed the record high set in 2000. Even those renowned for their consistent bearishness have turned positive - Richard Bernstein of Merrill Lynch expects double-digit stock returns this year.

Although the investment community appears to be almost universally bullish, corporate insiders, who are considered an excellent gauge of value, appear to be singing from a different hymn-sheet. US insiders have been aggressive sellers of stock in their own companies in recent weeks. Sellers have outnumbered buyers by a seven-to-one margin in recent weeks, the highest level in almost three years.

Valuation levels in both bond and stock markets provide little comfort. Price-to-book ratios are back to the levels of early-May and close to the levels that prevailed during the heady days of the late-1990s. Price-to-earnings multiples are currently close to 20 times on trend earnings, still well above historical averages.

A soft economic landing could be on the cards for 2007 and the Federal Reserve may duly comply with lower interest rates. However, this scenario is already reflected in financial markets. Indeed, the market movements since the summer are fully consistent with this hypothesis.

Current valuations provide little room for the alternatives - a protracted slowdown or higher interest rates for longer. Additionally, investors sometimes confuse declining volatility and the higher returns that accompany such a move for a higher return trajectory in the future. Consequently, monies are often directed to high-risk investments when expected returns have moved lower.

Now is not the time to go long on risk because a setback is in the offing.