NEW YORK (MainStreet) Despite a slow economic recovery with bits and pieces of momentum, investors are showing signs of complacency.
The Chicago Board of Options Exchange Volatility Index, or VIX, known as Wall Street's fear gauge, uses the options market to track volatility over the next 30 days and has been significantly below its historical average over the past few months.
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When investors are worried, they tend to trade options to hedge against potential equities losses in the broad S&P 500. This activity drives the VIX higher.
The VIX closed at 12.65 on Monday, up 3.86%, and dipped below 11 in early June. For perspective, during the financial crisis, the VIX reached a peak of 89.53 on October 24, 2008. The VIX tends to rise based on events that pose threats to the stability of the markets, such as bank failures, political instability or natural disasters.
But some analysts say the declines in the VIX mean investors are becoming too comfortable.
"It's unusual for the VIX to be this low for this long," says Mark Luschini, chief investment strategist at Janney Capital Management. "The VIX has historically averaged 20 and the markets could be poised for a breakdown."
While low volatility would suggest investors aren't worried enough about stock market declines to purchase insurance to protect their investments, there are a variety of economic factors that could hurt stocks.
Although bad weather played a role, the economy shrunk by 1% during the first quarter of 2014, according to the Commerce Department. Last week, retail sales increased a tepid 0.3%, the Commerce Department said, indicating weakness among the consumer.
The Federal Reserve is also grappling with quite a few conundrums.
Inflation seems to be rising faster than expected, with the consumer price index rising 0.3% in April, according to the Bureau of Labor Statistics, and up 2% year-over-year. The Fed's preferred inflation gauge, the personal consumption expenditure price index, fell 0.1% in April, but rose 1.6% over the past year. The Fed's inflation target is 2%.
The central bank is also is figuring out how to unload the $2.6 trillion it accrued on its balance sheet on the heels of the bond stimulus, known as quantitative easing. The Fed continues to scale back this bond stimulus, which is expected to wrap up in October.
"Even though U.S. economic growth is slow, it's pretty dependable," says Scott Wren, senior equity strategist at Wells Fargo Advisors. "There's complacency out there among investors, but I think the probability of a fundamental economic problem in the U.S. is pretty low."
A complacent investor with too much confidence may be unprepared to properly react should things go south.
Wren thinks the markets are more susceptible to event risk, as this is when the VIX spikes the most. For example, investors are watching the instability in Iraq, as this has started to push up oil prices, which will hurt consumers. If the situation escalates, the VIX could jump.
While the VIX speaks volumes about investor sentiment, some analysts are skeptical about the efficacy of the gauge.
"There's not much an investor should do based on the VIX," says Bill Ferrell, president and chief investment officer of Ferrell Capital Management. "The VIX was positive throughout 2012 and 2013 and was predicting volatility would spike and it never happened."
Ferrell says he's comfortable owning equities and likes periods of low volatility.
- Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE.