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Fear gauge shows complacency has taken hold

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A strong rally in U.S. stocks has pushed Wall Street's most widely watched risk barometer close to multiyear lows in a sign investors are growing increasingly complacent as equity indices test fresh record highs.

The CBOE Vix index, a gauge of the price traders are prepared to pay to protect against volatility in the U.S. stock market, has dipped more than 40 per cent since late June and neared pre-financial crisis levels by the start of the week.

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The combination of strong earnings, an increase in the flow of money into investment funds, improving economic data and limited trading activity during the U.S. summer season have set conditions for stocks to rise.

Reassurance from the U.S. Federal Reserve that interest rates would remain in place even as the central bank begins to taper its stimulus efforts also added to the positive sentiment.

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The Vix, known as Wall Street's fear gauge, moves lower when investors are more relaxed and touched its lowest level since March at 11.84 on Monday as the S&P 500 closed at a new record.

However, such low levels for the index have often been a precursor to reversals. Some analysts have started to ask whether investors are becoming too comfortable with the outlook for stock prices noting that the Vix jumped 7 per cent on Tuesday as stocks fell.

"The options market is essentially saying that the rally in stocks is accurate and complete with low volatility suggesting there is not much more upside left" said David Bianco, U.S. equity strategist at Deutsche Bank.

Other analysts have called the Vix a faulty gauge for market expectations, arguing that the actively traded contracts have become an asset class of their own rather than merely an indicator of potential risks lurking in the stock market.

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Nicholas Colas, chief market strategist at ConvergEx, said this may be the right time for investors to take a contrarian approach to the equity markets.

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"U.S. stocks currently reflect, both in price level and implied volatility, an economic acceleration which has yet to fully flower."

Appetite for stocks has pushed valuations on the S&P500 to their highest level since late 2007 at 15.5 times earnings. That comes as second-quarter earnings for S&P 500 companies have set a new record high, even though top-line sales growth has been limited.

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Investors have also injected billions of dollars into equities for five consecutive weeks even as other asset classes, in particular parts of the fixed income markets, have seen sharp outflows, according to Lipper data.

"But when it comes to Vix, people have to remember that it is a short time indicator. It doesn't tell us what is going to be happening a couple of months from now," said Mr Colas.