The VIX Is Getting Ready to Take Market on a Ride
Volatility's prolonged absence from the stock market appears to be coming to an abrupt end.
After being largely invisible for the past nine months—coinciding with a sharp equity rally—several signs indicate that instability is coming back.
Call options buying recently hit a three-year high for the CBOE's Volatility Index, a popular measure of market fear that usually moves in the opposite direction of the Standard & Poor's 500 stock index.
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A call buy, which gives the owner the option to purchase the security at a certain price, implies a belief that the VIX is likely to go higher, which usually is an ominous sign for stocks.
"We saw a huge spike in call buying on the VIX, the most in a while," said Ryan Detrick, senior analyst at Schaeffer's Investment Research. "That's not what you want to hear (because it usually happens) right before a big pullback."
The last time call options activity hit this level, on Jan. 13, 2010, it preceded a 9 percent stock market drop that happened over just four weeks, triggered in large part by worries over the ongoing European debt crisis.
"That obviously has been the smart money in the past," Detrick said. "We're not ignorant to the fact that this could be the same thing. The fears out of Europe for whatever reason spring up in the springtime."
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Technical strategists also have been watching the VIX's chart behavior. The optimistic case, Detrick said, is that Monday's major spike represented a one-off event that would not be repeated.
But Abigail Doolittle, technical strategist at the Seaport Group, said she sees a potential "ugly bottoming pattern" that could portend a messy time for the stock market.
Doolittle said she sees something "2011-ish" during which the VIX swelled beginning in June and stayed elevated during most of the year, when the market was essentially flat.
The S&P 500 could well test the 1,350 area - a 12 percent drop from current levels - or even see the 1,267 area, which would constitute an 18 percent tumble, she said.
"I still think we have a significant correction in store, well beyond a 2011-style event," Doolittle said.
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Nicholas Colas, chief market strategist at ConvergEx, said the VIX likely would be higher considering the level of domestic and global tumult—the Boston Marathon bombings, the North Korean nuclear scare, China growth slowing—but is being held down by Federal Reserve money creation and asset buying.
He said investors have two choices: Expect volatility return to the historical norm around 20 "and load up on any instrument which will profit" from the rise; or bet that the Fed's success in inflating stock prices can continue.
"On what planet is a CBOE VIX Index reading of 14 a fair assessment of near term stock market price volatility?" Colas said in a note to clients Wednesday. "A planet where Federal Reserve monetary policy still tightly holds the reins of capital markets, unless you have a better explanation of this clearly anomalous reading."