Calm Before Storm? What Low VIX May Mean for Stocks

Despite all the wild fluctuations in the stock market, investors remain remarkably complacent, which could come back to bite them if recent trends repeat themselves.

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The Chicago Board Options Exchange's Volatility Index , known as the VIX, is one of the most popular ways in which traders gauge market nerves.

Though by design an indicator of market activity over the next 30 days, the VIX is more often a gauge of immediate market sentiment.

The index has been in historically tame territory this summer, even as June offered three separate trading days of 200-point losses in the Dow and as geopolitical turmoil continues to circle.

"Lack of upside movement to the Volatility Index is indicating that we are in this neutral zone," says Art Hogan, managing director and head of product strategy at Lazard Capital Markets in New York. "Stocks are cheap, but nobody wants to buy them because there are too many macro concerns."

Those broader fears are well-publicized: Europe's sovereign debt crisis, the slowdown and impending "Fiscal Cliff" in the U.S., and global growth issues in China and other emerging market nations.

One reasonable explanation for the low VIX level — it's fallen by about one-third since its early June peak — is the simple lack of mid-summer stock marketvolume.

But Hogan thinks investors also may have become immune to the seemingly endless fits and starts in Europe's rescue plans, as well as the political machinations in Washington that likely only will be resolved after the November presidential election.

"Everything that's going on has been going on for a long time," he says. "In terms of the euro zone debt issue, it's a two-year-old problem that seems to get to the edge of the precipice and then pull back."

That mindset, though, could be trouble for the market.

Over the last two years, each time the market has reached similar levels as now it preceded a sharp spike in volatility, which in turn is always a signal that stocks are heading sharply lower.

The VIX traded at nearly an identical level in early July 2011 then doubled in a month's time, signaling a messy correction in the Standard & Poor's 500 that didn't come to a halt until the Federal Reservestepped in with an easing program called Operation Twist.

Any piece of unforeseen negative news could generate the same reaction.

"With such a low level of fear in the market, the negative reaction will be much more exacerbated. The concern is that if anything goes wrong we could have a fairly sharp selloff in the next couple of months," says Lance Roberts, chief strategist at StreetTalk Advisors, a Houston-based active portfolio management firm.

"There's going to be a wake-up moment in the next 60 days that does cause a relative selloff in the market somewhere between 5 and 10 percent," he adds.

If the selloff couples with another weak reading in second-quarter gross domestic product, that will gave Fed Chairman Ben Bernanke cover to institute another round of asset purchases known as quantitative easing, Roberts says.

The prospect of another round of QE has drawn some criticism lately, even though the market seems to depend on it.

Noted hedge fund manager David Einhorn, in a CNBC appearance, said more Fed easing would be "counterproductive," echoing sentiments of economists who believe a third round of QE would send a negative message.

"Each round of QE has had a dimished rate of return. A QE program now is highly unlikely because (Bernanke will) get very little bang for his buck," Roberts says. "He needs to have permission from the markets."

Indeed, some investors already are bracing for more volatility.

Open interest on VIX calls — a bet that the index is going higher — reached a record 4.64 million contracts for the June expiration.

Ryan Detrick, senior strategist at Schaeffer's Investment Research in Cincinnati, said the demand for VIX options is so high that it might even be approaching bubble levels and perhaps not as good an indicator of future performance.

"So many people are predicting potential higher volatility that we're taking the contrarian approach," he says. "If people are expecting that higher volatility, will we truly have that massive spike?"

If the market can back off its volatility fears it could pave the way for a powerful rally, says James Paulsen, chief market strategist at Wells Capital Management in Minneapolis.

Comparing the Consumer Confidence Index to stock market levels, Paulsen said if confidence would improve toward its trendline that could push the stock market in turn toward its longer-term trendline, which would result in a rally approaching 25 to 50 percent.

Ever the optimist, he is holding to his market call this year for the S&P 500 to hit 1,500, based primarily on the notion that if investors can get over their geopolitical fears, the market will follow.

"There is a lower unemployment rate, there is less debt burden, there is bank lending, there is housing activity showing up now, which makes our economy less vulnerable to a crisis than it was a year ago," Paulsen says. "Maybe that's what some of these indicators are saying in their invisible-hand wisdom."