VIX Fear Gauge to Induce Worry in the Stock Market

Finally, last Friday, the US stock market snapped its winning streak. Eight winning sessions in a row did not become nine, as the Dow slumped 37 points to 10,742. But even so, the US stock market has been delivering surprisingly strong performances of late, especially when one considers that the economy hasn’t been.

Day after day, stocks inch higher, despite the fact that the economy merely muddles along. This trading action would seem more reasonable if stocks were cheap. But they aren’t. Based on consensus estimates for 2010, the S&P 500 Index is selling for more than 21 times earnings. We use to call that “expensive.”

Nevertheless, in a world of microscopic money market yields, stocks seem like a less ugly option to many investors. We understand the appeal of an asset like stocks that might deliver SOME return, compared to an asset like one-year T-bills that offer next to NO return. On the other hand, we also understand that the return stocks might deliver might not be a positive one.

Sometimes 40 basis points in the hand is better than getting your rear-end handed to you.

Your editors are not predicting that the stock market will soon begin to malign investors rather than comfort them, but neither are we ruling out the possibility. We are uncomfortable with the smug confidence that inspires new “buy” orders at 21 times earnings. Now that the S&P 500 has rallied more than 60% in just 12 months, most stocks are probably better sold than bought.

“The May VIX is at 21.70, which is 5.10 above the cash VIX of 16.60,” observes Jay Shartsis, an options expert with R.F. Lafferty in New York. “The June VIX is at 22.60 which is 6 points above VIX. That’s a gigantic premium, and is very unusual. This big premium in the May and June contracts suggests a big jump is coming in VIX…and that means a sharp drop in stocks.”

The VIX Index, also know as the “Fear Gauge,” measures the implied volatility of certain option contracts. As such, it measures the relative fear or complacency of option traders. When the VIX Index is very low, as it is currently, option traders are relatively complacent, which is a danger signal. When the VIX reading is high, option traders are very fearful, which is usually an indication that stocks will soon begin to rise.

The observation made by Shartsis incorporates one additional wrinkle: the relative pricing of near-term VIX contracts. These near-term contracts tend to lead the VIX Index. Thus, when a big premium opens up between the near-month contracts and the cash VIX, as is currently the case, the “smart money” is starting to become worried about the stock market.

Be forewarned, the smart money is worried…and so are we.

Eric Fry
for The Daily Reckoning