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‘Fear gauge’ slumbers, but not fear itself

Trader Mario Picone works on the floor of the New York Stock Exchange in this June 1, 2012 file photo.

Reuters

A closely watched gauge of investor sentiment is signalling nothing but cool breezes and sunny skies ahead for the stock market – but for observers who look for contrarian signals, that could be a sign of trouble.

The CBOE volatility index (or VIX) measures expectations for near-term volatility in the S&P 500. It spikes when nerves are frayed and burbles along at low levels when confidence is strong, and it is now approaching what has traditionally been its trough of about 15.

On Tuesday in midday action, it fell to 16.34 down 0.46, marking the lowest level since the start of May and down more than 40 per cent since the start of June.

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"Note that while the VIX has slipped below 15 on occasion, it has eventually bounced off of this support level in each instance and, perhaps more notably, a VIX bottom in the 15-18 range has also coincided with a top in the S&P 500 each time around," said Bill Luby, a close observer of the VIX index who writes a blog called VIX and More.

The index has been on a rocky ride in recent years. It surged above 80 in late 2008, during the height of the financial crisis after Lehman Brothers failed. Since then, it has jumped above 40 on a number of occasions, with the Japanese tsunami and flareups in the European sovereign-debt crisis acting as the most obvious drivers. It has settled back each time.

This incredible volatility in the volatility index – it can double in a matter of days – has brought a great deal of attention to the VIX in recent years, and spawned a number of investments that attempt to capitalize upon its gyrations. For example, there's the iPath S&P 500 VIX short-term futures exchange-traded note (pity me: I own units of this ETN) and the ProShares Ultra VIX short-term futures exchange-traded fund, which is designed to give twice the daily performance of the VIX.

Of course, there is nothing about a low reading on the VIX that spells trouble ahead; it is not a crystal ball. However, low levels can reflect investor complacency, making it a handy indicator for anyone expecting the stock market to turn rough at the first sign of disappointment.

And it is not as though the world is firing on all cylinders right now. The European debt crisis continues to simmer, despite an agreement among leaders on Friday to make it easier to recapitalize struggling banks. The yield on Spain's 10-year government bond has retreated to 6.3 per cent from a euro-era high above 7 per cent in mid-June – but is still at a level that points to unsustainable borrowing costs.

Meanwhile, the yield on the U.S. 10-year Treasury bond is just 1.61 per cent, a level so low that it suggests bond investors remain highly skeptical of the U.S. economic recovery – a view bolstered by high weekly initial jobless claims, slow economic growth in the first quarter and a contraction in manufacturing activity in June.

The U.S. second quarter earnings seasons begins next week with Alcoa's Inc.'s report. Analysts have been busily slashing their estimates for companies within the S&P 500, raising anxieties over whether the economic headwinds are going to be reflected at the corporate level.

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But with the VIX in a comfy slumber right now, you wouldn't know that concerns persist. Maybe that's the biggest concern of all.

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More

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