The VIX is easing off

Market volatility is synonymous with market uncertainty and fear. It became a primary characteristic of market behaviour since October last year. Now, there are signs volatility is subsiding, or is it too soon to tell?

Nick Godt, reporter of MarketWatch published the following story:

The Chicago Board Options Exchange's volatility index (VIX), otherwise known as the market's fear gauge, has slumped to levels in the last few weeks unseen since before the collapse of Lehman Brothers last September.

"The rally is losing momentum, which is not terribly surprising," said Ken Tower, chief market strategist at Quantitative Analysis Service. "Is the VIX dangerously low? I would say it's close." On Tuesday, the VIX slumped 4.8% to 28.80, a level last seen in early September 2008, just days before Lehman Brothers shut down. The announcement had sent the VIX sharply higher, a move up that continued through December.

The broad market, as measured by the S&P 500, remains up more than 36% since hitting lows in March. On the face of it, lower fear and volatility sound like a good thing. It means investors are more confident to take on risks.

For contrarian investors, the fear gauge, when it reaches extreme levels, is seen as likely to pull back the other way much like an over-extended elastic. And it is therefore all the more fuel for a rally when it does.

But now that the VIX has fallen back sharply, some analysts believe the pulse of the market is at risk of being too tepid and stocks might be facing another leg down.

"This might mean that we're eventually headed for a setback," Tower said. "I still see this as a stabilizing market in a stabilizing economy, but [the market] has come a long way very quickly."

According to FactSet Research, the VIX spiked to record highs of between 81 and 96 in late October, as panic gripped markets worldwide.

From 2003 to July 2007, readings below 20 were the norm. as the market continued to climb during the housing bubble and before the credit crisis surfaced. But by March 2008, as Bear Stearns nearly collapsed, the VIX had jumped above 30 before falling back.

Some, such as currency strategists at BNP Paribas, now believe that the rally will have ran out steam when the VIX reaches 25.