Wall Street’s ‘fear index’ falls to lowest since 2007; a good excuse to sell?

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When the inevitable significant sell-off finally hits the stock market, every bear will say, “I told you it was coming.”
Never mind that the inevitable significant sell-off -- something bigger than a 10% drop -- has eluded the bears, and bargain-hunters, for the last 13 months.

Major U.S. market indexes have rallied between 70% and 100% over the last year. You’ve left a lot of money on the table by avoiding stocks, however sound your reasoning might have been.

Now, with the Dow Jones industrial average on Monday crossing 11,000 for the first time in 18 months, many bears and bulls alike are expecting some kind of market give-back soon. “We’re due” is a phrase in heavy use by both camps.

The bulls’ nervousness stems in part from the remarkable steadiness of the latest advance: The Standard & Poor’s 500 index has climbed 13.2% since Feb. 8, and in that period the index has fallen more than 1% in just one session (Feb. 23, when it lost 1.2%).

That smooth ride higher has beget expectations of more of the same. The accompanying chart shows the so-called VIX index, which gauges investors’ expectations of near-term volatility in the stock market. The index fell on Monday to 15.58, its lowest level since mid-2007.

The VIX, dubbed Wall Street’s fear index, is calculated based on trading activity in S&P 500 index put and call option contracts. Investors and traders use options either to bet on market swings or to hedge against them.

When the VIX falls sharply it signals that many investors and traders believe the stock market has a relatively placid outlook, and that fear of steep drop in share prices is low. When the index rockets it says the opposite -- that investors expect that things are going to get much worse for the market.

At either extreme, the VIX can be a great contrarian indicator: It’s often better to bet against the crowd at those points.

The problem is that extremes in the VIX are only evident after the fact.

The index has been declining, in fits and starts, since it peaked at 80.86 in November 2008, as the financial system was careening toward disaster. Relative to that high, 15.58 looks extraordinarily low, suggesting an extreme amount of complacency in the market.

But there’s no rule that says the VIX can’t go lower than the current 15.58. Indeed, in 2006 and 2007 the index was routinely below 15 on a daily basis, and sometimes below 10.

If you’re expecting a stock sell-off soon because things just seem too good to be true, the VIX at these levels probably will reinforce that feeling.

Unfortunately, whether the VIX is warning of a severe market decline ahead, a modest pullback -- or just more clear sailing -- will only be clear in retrospect.

-- Tom Petruno