Complacency Could Signal Violent Sell-Off
The most popular way to measure market fear — the CBOE Volatility Index — fell to its lowest point of the four-year bull market, signaling to many traders a level of complacency that sets in before a powerful drop in stocks.
"The next few weeks or months could be treacherous for shorts, but the odds favor a volatility spike of fairly epic proportions off of what is a very depressed level," said Dan Nathan, co-founder of RiskReversal.com. "I think you would have to have your head checked to load up on equities here."
The so-called VIX dipped below 12 for the first time since April 2007. The metric measures market expectations for volatility by comparing prices paid for put options on the S&P 500 (bearish) relative to call option prices on the index (bullish).
U.S. stocks began their bull market in March 2009 and the S&P 500 has jumped 130 percent since its intraday low that month. The index is less than 1 percent from a record high. The Dow Jones Industrial Average hit a record level last week.
"Bullish opinions are rampant," said Brad Lamensdorf, who runs the Ranger Equity Bear ETF (HDGE), which specializes in finding stocks to bet against. "Sentiment gauges are flashing a warning sign: Good luck, Bulls!"
These investors and many others figure that when investors are this unconcerned about protecting themselves from a selloff, then a drop must be near for a market that has shown the historical tendency to fool the most people, most of the time.
However, the track record for timing the market with the VIX is tough to judge accurately. Generally, it does fall to low levels before a troublesome event occurs. The problem is that in many cases the measure can remain low for a pretty long time before that event occurs.
The bulls look at a U.S. market that has stopped paying attention to the dysfunction in Washington, D.C., and that is apparently unfazed by blips in the European comeback story and see no reason to stop buying.
"The Fed's real goal is not (necessarily) to lift stock prices but has been, and will continue to be, to dampen volatility," said Nicholas Colas, BNY ConvergEx chief market strategist. "It just so happens that lower volatility usually comes with rising capital markets. So we get this long term — but slow — melt-up on ever lower volatility."