Stock-market 'fear gauge' tumbles to nearly 4-year low. That makes some traders extremely nervous.

By Joseph Adinolfi

Markets are looking dangerously complacent, strategists say. And there is data to back this up.

Wall Street's favorite "fear gauge" has hit its most subdued level since before the pandemic after investors threw caution to the wind and bid up stocks at the fastest pace in years.

But rather than signaling that stocks are set to keep marching higher into the end of 2023, some analysts fear that the Cboe Volatility Index VIX, better known as the VIX, is sending an alarming message: Wall Street has become dangerously complacent in its assessment of looming threats, meaning any negative near-term shocks could send markets reeling.

David Rosenberg, founder of Rosenberg Research and a former Merrill Lynch economist, described the market's mood as showing signs of "excessive optimism," in a missive to clients shared with MarketWatch Monday morning.

On Friday, the VIX closed at 12.46, its lowest closing level since Jan. 17, 2020, when it closed at 12.10, FactSet data show.

Meanwhile, the Cboe S&P 500 9-day Volatility Index XX:VIX9D, which gauges implied volatility over a much shorter time horizon than the traditional Vix, closed at 9.83, its lowest since Jan. 10, 2020.

A low Vix means option traders aren't paying up to protect their portfolios from a selloff over the next 30 days. While that might sound like a positive for markets, low levels of implied volatility are typically followed by a spike higher, as Nicholas Colas, the co-founder of DataTrek Research, pointed out in a note to clients shared with MarketWatch on Monday.

Consider these factoids, courtesy of DataTrek:

Over the past five years (equal to 1,260 trading days), the VIX has only closed at or below Friday's level in 25 sessions, roughly 2% of the total. 5 of those were in January 2022, just before the pandemic-inspired market selloff began. A VIX of 12 is one standard deviation -- or eight points -- below its long run average. While it can rise between one and five standard deviations above this long-term mean during a crisis, the index rarely trades at one standard deviation below the mean for extended periods. The VIX has only closed below 12 on three days in the last five years, and all those readings occurred in November 2019, four years ago almost to the day.

But setting aside these historical trends, the fact that options traders seem to be ignoring such a disparate array of threats is enough to give Colas pause.

"Simply put, U.S. options markets have put inflation worries, aggressive central bank monetary policy, geopolitical uncertainty, corporate margin pressures, and higher long term interest rates entirely behind them. Remarkable, but true," Colas said.

"Yes, seasonality is a factor, but that alone does not explain an abnormally low VIX. Rather, markets think they have everything figured out."

While seasonality can help explain why option buyers might seem so sanguine, it can also cut both ways, as another strategist pointed out.

Jonathan Krinsky, chief market technician at BTIG, said he expects to see the fear gauge climb heading into the end of the year, ushering in some last-minute volatility for stocks and potentially crushing hopes for a Santa Claus rally.

"Volatility is a funny thing because it is often mean reverting unless we are in a new regime," Krinsky said in his report.

Perhaps the best example of a painful reversal in the market's fortunes arrived in February 2018, when a popular short-volatility trade that helped send the VIX to record lows in late 2017 suddenly unwound, causing stocks to tank and several exchange-traded short-volatility products to implode.

This episode was remembered on Wall Street as "volmageddon," and it saddled traders, including many retail traders, with billions of dollars in losses, while the Dow Jones Industrial Average DJIA sank more than 1,000 points in a single session on Feb. 5, 2018, according to FactSet data. At the time, it was the blue-chip gauge's biggest single-day drop on record.

To try to put this into context, Charlie McElligott, the Nomura options-market guru, explained how the Federal Reserve's latest messaging shift helped drive the current VIX "vol crush." He warned clients Monday that the calm likely won't last.

"Eventually, this resumption of exposure building and 'short vol' positioning will allow for 'stability to breed instability,'" McElligott said in his latest note to clients.

A "fresh vol catalyst" must arrive to set the unwind in motion, McElligott said. That likely won't happen until 2024, and anticipating the exact nature can be difficult.

That didn't stop McElligott from rattling off a couple of possibilities. They included a reacceleration in U.S. economic data that forces investors to re-evaluate the possibility of interest-rate cuts in 2024, and the Bank of Japan finally abandoning its ultraloose monetary policy, sparking another bout of volatility in global currency and bond markets that spills over into U.S. stocks.

During the four weeks through Friday, the S&P 500 rose 441.97 points, according to Dow Jones Market Data. That was the largest four-week point gain since April 2020. What's more, all 11 of the index's sectors have climbed over the past two weeks for the first time since June 2020, according to an analysis from Callie Cox, U.S. investment analyst at eToro.

As of Friday's close, the S&P 500 was just 0.7 percentage points shy of its 2023 closing high, reached on July 31, and less than 5% shy of the record high reached Jan. 3, according to FactSet data.

On Monday, the VIX was trading higher, but remained mired below 13. The S&P 500 SPX was off 5.5 points, or 0.1%, at 4,533. Typically, implied volatility, which is calculated using trading volume in certain S&P 500-linked options products, moves inversely to the S&P 500.

-Joseph Adinolfi

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11-27-23 1348ET

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