Wall Street's fear gauge has dipped below a key level. Why that could mean more trouble for stocks

Published Tue, Jan 17 20231:58 PM ESTUpdated Tue, Jan 17 20235:15 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

Wall Street's favorite volatility gauge appears to be signaling a calm stock market and complacent investors, but strategists say it's likely a prelude to more market volatility and a potential rout in the S & P 500. Cboe's Volatility Index , a measure of expected market volatility based on put and call options on the S & P 500 , fell below 20 last week and traded below the key level again Tuesday. It was last at 19.27. "The old saying is hedge when you can, not when you have to," said Julian Emanuel, head of equity, derivative and quantitative strategy at Evercore ISI. "The VIX below 20 is the absolute epitome of hedging when you can, not when you have to ... whether it's upside or downside." Emanuel said there are several catalysts for volatility. The earnings season could contain unexpected negatives for stocks, while the Federal Reserve on Feb. 1 is expected to make a rate announcement and provide some guidance on more rate hikes. Early Wednesday could also provide some shocks, depending on whether the Bank of Japan sounds more hawkish at its policy meeting, he said. Emanuel said contrasting those potential negatives to the fact that investors are snapping up last year's losers and betting on risk in things like bitcoin is sending mixed signals on the direction of the market. "There is an inherent confusion going on here," he said. "Frankly since December, the market has done an excellent job of fooling most of the people most of the time. ... Here, the winners are losing, and the losers are winning. And nobody has the right positions by and large." .VIX 1Y line vix That in itself is a reason for higher volatility. Strategists see the low VIX as a warning that the volatility will be a downside move for stocks, which has been expected by many investors for the first half of the year. "It's a warning signal for the S & P 500, which does uphold an inverse correlation for the VIX," said Katie Stockton, founder of Fairlead Strategies. She said the low VIX reading is associated with a short- and intermediate-term oversold market, which indicates complacency among investors. "With the assumption that the bear market cycle still has a hold, the VIX has found support in this range. All throughout 2022, once the bear market cycle began, the first low was late March to early April, and it was in this range," she said. Stockton said the second time was in August, and the third was early December. Each time, the S & P 500 subsequently sold off. .SPX 1Y line sp She is now watching to see if the fear gauge will rise to its 50-day moving average and close above it. The 50-day, or the average of the last 50 closes, was at 22.13 on Tuesday. A close above that level could signal more upside for the VIX and potential downside for the S & P 500, which has initial support at 3,800. The higher the VIX goes, the more volatile the move in stocks could be. "We're watching the 50-day moving average [on the VIX] as a risk metric for the S & P 500," she said. Stockton said she expects the stock market to consolidate this week, beginning a pullback as investors consider earnings and economic data. Stockton said the VIX could go a lot higher this year, particularly if the market tests its lows and breaks them. "Looking over the history of the VIX, there has rarely been a bear market cycle, or even a corrective low that occurs without a move into the high 40s, mid-50s range," she said. "Looking at past major routs in the S & P 500, it's always associated with a VIX at a much higher level. Obviously, that would require a shift in market sentiment to get the VIX there because of the nature of how it's constructed." She said there is a lot of skepticism surrounding the predictive power of the VIX as a sentiment gauge. "We're kind of skeptical of the skeptics," she said. How to play it Susquehanna's Chris Murphy said the VIX has been a powerful signal in the past 18 months. He said when the VIX falls below 20, it's been a signal to sell the market. When it rises above 30, it's time to buy. "Ever since the Fed became hawkish in late 2021, this trend has been clearly better than buy and hold, and it's a pretty good market timer for those who have been actively trading the market," said Murphy, co-head derivatives strategy at Susquehanna International Group. Longer term, the trend did not work better than buy and hold since the VIX, for example, fell below 20 and stayed below for a long period in 2016 and 2017. Investors would have missed out on gains in those years if they followed the sell strategy. But there are other ways to play a down market that could be easier and cheaper for investors. "Not only if you don't want to get out because you don't want to miss an opportunity like 2016 and 2017, hedging is attractive here," he said. "The hedging costs are lower. You could buy puts that are a lot cheaper." Emanuel recommended in December that investors hedge for both upside and downside volatility in the S & P 500 in the first quarter. That strategy involves buying March 31 S & P 500 puts and calls that are out of the money. He said that since the October low, the index has been in a range between 3,500 and 4,100, so he recommended puts at 3,500 and calls at 4,100. That way investors could benefit from sharp swings in either direction. A put option gives the holder the right to sell an asset at a set price, known as the strike price. When the value of the asset is trading above the strike price on the put option, then the option is "out of the money." A call option simply gives the owner the right to buy an asset at a given strike price. When the value of the underlying asset is trading below the strike, then the call is "out of the money." Murphy said it seems the volatility in the S & P 500 will be to the downside. "I think the general thought has been that everybody was looking for the first quarter for all sorts of other things to be washed out," he said. "I'm kind of on the fence, thinking the real reset is going to be pushed out a little bit."