Montreal, Canada

Investors are now more bullish on stocks than at any other time since early 2007.

One of the most widely watched gauges measuring investor sentiment is the American Association of Individual Investors' Sentiment Survey (AAII). Back in March 2008 when the financial system was imploding and stocks were hitting 12-year lows this index stood at massively bearish levels; as of January 14, 2010 the index sits at 47.44% bullish – its highest level since February 2007. Back in August 2009, the AAII survey stood at 34.07% bullish.

The AAII index is interesting to watch because it generally tracks what the individual investor and advisors are doing in the United States. It also acts a contrarian signal for the bears – many anticipating at least a 15% correction following a spectacular rally over the last 10 months.

The AAII sentiment index also matches current sentiment data from the CBOE Volatility Index of S&P 500 options fear gauge.

The VIX continues to plunge almost weekly since last spring and now trades at its lowest levels since May 2008 at just 17.85. The VIX has crashed more than 63% over the last 12 months and is already down 18% this month. Market participants are wagering that volatility will continue to decline to 2005-2006 levels when global macroeconomic events and corresponding shocks were basically nil. The odds that volatility levels will remain low or even head lower in this post-credit crisis environment is low. Complacency has returned en masse at a time when banking reform, securities legislation and "too big to fail" continue to remain important unresolved issues.

In fact, I would argue that speculation has largely returned across many financial centers with hedge funds now assuming leverage again from their prime brokers since Q4. Banking reform has gone nowhere and clearing platforms to settle lethal credit derivatives are progressing at a very slow rate. Nothing has been done to protect the financial system ahead of the next blow-up, which I believe is inevitable. In previous columns I've suggested the nest crisis is already in the making, probably at the government level as defaults loom in the OECD.

Finally, speculation is now at an all-time high in the emerging market whereby mutual fund flows are booming. Investors are lunging after the China story with reckless abandon, similar to the red-hot technology mania in the late 1990s. Blind optimism has been accorded to the Chinese economic miracle. It is unreasonable to expect China to continue to grow at 8% per year indefinitely without some sort of massive financial dislocation. I shudder to think what would happen amid a Chinese crash – commodities and stocks worldwide would get crushed while most other risk-based assets also plunge.

Hedging strategies continue to get cheaper by the day over the last several months. But, as investor sentiment continue to grow more bullish, it's quite obvious that some of the best bargains now lie not in stocks or commodities but in aggressive strategies that can protect your downside. These include the VIX, the Japanese yen, Treasury bonds, the dollar, gold and diversified managed futures, which remain in a draw-down since last year.