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What the 'fear index' is telling investors about markets now and into 2017

The so-called fear index shows that investors are feeling content right now, but volatility could be coming as markets roll into 2017.

The CBOE Volatility Index (.VIX), fell below 11.5 Tuesday to its lowest level since Dec. 8, coming within half a point of the year's low at 11.02. Meanwhile, stocks continued their rally Tuesday, with the Dow Jones industrial average and Nasdaq composite setting record closes.

"Everything about it is telling me people are kind of apathetic about what's going to happen for the rest of the year," said JJ Kinahan, chief strategist at TD Ameritrade.

"Next week, you may see people suddenly starting to hedge themselves," he said, noting concern about the strong dollar's impact on U.S. earnings. "The real question starts to become, as we get closer to earnings, [do] people start to hedge themselves for an overall market sell-off?"

Typically, a low VIX signals a market that's comfortable with current levels. But as 2016 winds down, some analysts say the low levels in the VIX and improved outlook on growth potentially set the market up for disappointment — and greater volatility ahead.

VIX year-to-date performance

Source: FactSet

"A lot of sentiment gauges are telling us there's plenty of optimism in the market right now, and we have to be on the alert when that optimism rolls over," said Ed Clissold, chief U.S. strategist at Ned Davis Research Group. When it comes to the "VIX, we want to see it reverse from extremely low levels."

Wednesday is the last day to trade the VIX contract for December, and trade volume was significantly higher on the January contract, which was trading just above 14.

The VIX measures the buying of put and call options on the S&P 500 near-term options and is generally considered the best gauge of fear in the market. Puts and calls give the buyers the right to sell or acquire an asset, respectively, at a preset price.

Now, at least to one analyst, the VIX may be an indicator that investors are almost acting in "fear of missing out" in the rally.

Peter Tchir, head of macro strategy at Brean Capital, pointed out that four times this year the VIX began edging higher with stocks around risky events, before equities sold off and the volatility index jumped.

"I think it's not only telling [us] complacency. It's almost talking about greed to me," Tchir said. "People are buying calls rather than buying puts."

Last week, Mandy Xu, derivatives strategist at Credit Suisse, pointed out that demand for calls reached an all-time high.

With the election over, "investors feel like they have the world figured out," and "with a clear playbook, there's less volatility," said Nicholas Colas, chief market strategist at Convergex.

Popular bets right now include bank stocks and small-cap names, which many analysts say should benefit from President-elect Donald Trump's promises of tax cuts, infrastructure spending and deregulation. It's still unclear, of course, whether those proposals will help stocks — or if they will happen at all.

"You may have a playbook," Colas said, but "you may still lose the game."

Meanwhile, the year ahead brings other risks — dollar strength, the U.K.'s formal negotiations to leave the European Union, other European elections, and violence or the potential for it.

While 2016's market calendar had many defined events, 2017 is "going to be a year where people are going to come in complacent into events that aren't scheduled," said Ilya Feygin, managing director and senior strategist at WallachBeth Capital. "Trump's policy has no dates."

The only date analysts have to look toward so far is the Jan. 20 inauguration, from which the clock begins ticking on the president's first 100 days.

Other factors, such as major moves within S&P 500 sectors and lack of buying interest, are behind the low VIX, analysts said. December is also generally a low point of the year for the VIX, Colas said.

"The kind of funds that have typically paid up for that downside are simply not paying up (now) because they've been burned," said John Wilson, CEO of Sprott Asset Management.

That said, the straight-up market rally that's sent the Dow within striking distance of 20,000 may have some credible reasons to hold its gains.

"We would argue the market is here because of the economic fundamentals, not because Donald Trump won the election," said Scott Wren, senior global equity strategist at Wells Fargo Investment Institute.

"The market might concern itself with things that might and could happen two or three years down the road … but very quickly you get back to fundamentals," he said. The Wells Fargo/Gallup Investor and Retirement Optimism Index jumped to a nine-year high of 96 in the fourth quarter, still below the plus-130 level Wren would consider as a negative for stocks.

In addition, analysts resist comparisons between the postelection market rally today and the the dot-com bubble at the turn of the century. The Dow first topped 10,000 in 1999, and the VIX at that time was above 23, nearly twice where it was Wednesday.

The Dow "was really being dragged higher by the tech stocks of the late '90s, and since tech stocks have higher volatility … the base volatility of the market was higher," Colas said.

Correction: This story has been updated to reflect that the December contract expires Wednesday.