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Stocks can still go lower because investors aren't scared enough

Key Points
  • A reading of investor fear suggests traders are not as afraid now as they were during past big market sell-offs.
  • Contrarians say fear may need to increase — and stocks may need to slide further — before the market becomes oversold and reaches a trough.
  • "Given that optimism was not as high in July, pessimism may not have to get as extreme this cycle, but lower readings may be needed," Ned Davis Research says.
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A key measure of investor fear suggests the stock market may have further to fall.

The Cboe Volatility Index, known as Wall Street's "fear gauge," hit a 2019 high on Monday as the U.S. stock market had its worst day of the year. The index, which tracks options prices on the S&P 500, swung back toward that level again during the Wednesday morning sell-off. When it rises, it means investors are getting worried and paying more for to hedge against a market drop.

But the measure is still well below the level it hit during a severe market correction last December. This suggests that fear may need to increase — and stocks may need to slide further — before the market reaches a trough.

So there's fear on the trading floors, just not enough.

"Given that optimism was not as high in July, pessimism may not have to get as extreme this cycle, but lower readings may be needed," Ned Davis Research analysts Ed Clissold and Thanh Nguyen wrote in a note.

Contrarians believe once the sell-off has washed out the weak hands and caused them to sell, the market can rebound again.

The volatility index closed at 24.59 on Monday, at one point reaching 24.81. It had closed above 20 only once before in 2019. On Wednesday, the index reached 23.67 at one point as the S&P 500 dropped 1.95%, but closed below 20 after the market rallied.

The measure closed at 36.07 on Dec. 24 after the Dow Jones Industrial Average shed 653 points in a Christmas Eve sell-off.

Ned Davis' own measure of investor sentiment shows a similar story. When it declines, it means fear is increasing. The reading in the NDR Daily Trading Sentiment Composite was 35.56 on Tuesday. The composite fell below 20 during the June pullback and below 10 during the December market correction.

Source: Ned Davis Research

Barclays warned that the trade war and potential for further rate cuts by the Federal Reserve could create a "soggy soft patch" that keeps the market from rebounding, but also noted that there are "no signs of panic yet."

"The selloff was broad-based, and although assets exposed to trade war and growth slowdown underperformed, the pessimism is not extreme," Barclays said in a client note Wednesday.

Nomura strategist Masanari Takada sounded a more ominous tone earlier in the week, saying that the next sell-off could be "Lehman-like " as algorithm-driven traders unwind bullish positions.

"We would expect any near-term rally to be no more than a head fake, and think that any such rally would be best treated as an opportunity to sell in preparation for the second wave of volatility that we expect will arrive in late August or early September," Takada said.

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