Has the Decline in Volatility Lulled Investors Into Complacency?

A period of exceptionally quiet trading has lulled investors into a sense of complacency that, by some measures, has not been seen in years. After the stock market crash in the Fall 2008, the rally off the November lows was followed by a sharp decline in actual levels of market volatility. For example, the 20-day historical volatility of the S&P 500 has fallen back to 33 percent and its lowest levels since mid-September. Compared to October and November, the S&P 500 hasn’t been moving much. The uneventful trading seems to be giving investors a renewed sense of comfort or confidence. Risk aversion is falling.

The recent decline in the CBOE Volatility Index (.VIX) is one sign that risk perceptions have been falling. After reaching extremes near 90 during the market collapse in October, VIX has been in freefall and slipped another .52 to three-month low of 38.56 Tuesday. The VIX, which tracks the expected volatility priced into S&P 500 Index (.SPX) options, is sometimes called the “fear gauge” because it tends to move higher when stocks fall and demand for portfolio protection (SPX puts) is on the rise.

While the decline in the volatility index is a reflection of a much less volatile equity market in a post-crash world, it also mirrors a surprising shift in investor attitudes. The change in sentiment is reflected in a few other indicators as well. For example, the ISE Sentiment Index [ISEE] has been heading higher. ISEE is a unique indicator that is computed as the day’s call buying divided by put buying on the International Securities Exchange [ISE]. When the index rises, it suggests that call buying is picking up (relative to put buying) on the largest exchange for trading puts and calls.

The International Securities Exchange updates ISEE throughout the day and also breaks the indicator down for equity options and index/ETF options trading. The (ten-day average) of the equity-only ISEE is plotted below. It recently rose to 172 and its best levels since mid-May. A reading of 172 suggests that put buying is running at 58 percent total call buying.

Figure 1: ISEE Ten-Day Average

The total put-to-call ratio is telling an interesting story as well. The ratio is computed as the day’s put volume divided by call volume for options trading across all seven exchanges. Figure 2 plots the 10-day average. Like the VIX, it has been in freefall in recent weeks and the ten-day average hit .71 late last week–its lowest levels since….December 2006!

Figure 2: Total Put-to-Call Ratio

Clearly, rising levels of bullish sentiment are fueling the recent rebound in the equity market. This is a powerful trend that can continue for quite some time, even if some indicators signal that the equity market is overbought. In addition, some technicians might point out that the recent advance has been constructive. Not only did the S&P 500 break above its December highs last Friday, but it is also making a decisive move above its 50-day moving average. The trend is your friend.

At the same time, however, low volume and light news due to the holidays is one reason for the declining volatility during the final two months of December.

A real test of the market’s resiliency and investor conviction might come later in the week when payroll data are released Friday and or when the earnings-reporting season gets under way in a couple of weeks. Can the market’s underlying tone remain constructive if and when investors get hit with another barrage of disappointing economic and earnings numbers?

Stock position: None.