Investors becoming complacent is usually not a good thing and a harbinger of some sort of short-term shock. The market has an uncanny ability to make a lot of people look foolish the majority of the time, so when things become too easy for an extended period of time, look out the other way. How is investor complacency measured? Enter the VIX.

What Is It?

The VIX is short for the CBOE Market Volatility Index, which is a gauge of implied volatility of S&P 500 index options. Basically it measures volatility and is commonly referred to as the “fear index” on Wall Street. The derivation of the VIX is pretty complicated and beyond the scope of this article, but a key point is that it is a gauge for the variance or volatility for the stock market (as denoted by the S&P 500) over the next 30 days.

It is tough to base an investment strategy solely on the VIX, but it is a useful indicator, especially when it hits the extremes. During the crash of 1987, the VIX hit an unheard of level of 150. According to Wikipedia, the average level of the VIX from 1990-2008 was about 19. The rule of thumb is that an extremely high VIX indicates fear and is a good time to buy based on contrarian investing. The rationale is that people are scared and selling so it is prudent to pick up their shares. On the other hand, a low VIX shows complacency and often times indicates market tops. Among academic circles, the VIX squared can be the market’s expected return for the next year. For example, a VIX of 40 would give an expected return of 16%. Of course this is a rough approximation.

Where We Are

VIX

The VIX is currently around 19, which is the average for the past 20 years, but it has come down significantly over the past few months as the market has moved higher. It is approaching levels not seen since April when the market rolled over and experienced a swift correction. There is no hard and fast rule as to what is considered complacency, but I believe we are in that vicinity right now. By itself, the VIX at this level is not a sign to panic, but it is one more feather in the cap of those who think we are overdue for a cleansing correction. Count me as one of those people.

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