Investors, get ready for a nasty surprise

The Dow Jones industrial average fell below its 50-day moving average on Tuesday, scything below a level that has held the index since early April. This came as a shock to many, given just how complacent investors had become.

The Dow closed at 16,375, down 138 points on the day. With the loss of such an important technical level, additional selling pressure is likely going forward.

And for investors used to the low volatility environment of the past few weeks -- which led New York Federal Reserve Bank President William Dudley to comment today that such quiescence is becoming a concern for policymakers -- such pressures are going to come as an unwelcome surprise.

The current level of investor complacency is evident in how the Chicago Board Options Exchange Volatility Index (VIX), known colloquially as Wall Street's fear gauge, has compressed. The index measures how worried options traders are about a potential decline in the market. When it's high, investors are paying up for portfolio protection. When it's down, as it is now, it's a sign they aren't that worried.

052014indu.png

The problem is that traders and investors are too good. This, too, is visible in the way that short-term volatility expectations, as measured by the VIX, have compressed relative to medium-term volatility expectations to an extent consistent with recent market tops. We're at levels that were seen at the market highs in January and September, but aren't quite at levels associated with the November and August tops.

Another sign of complacency can be seen in the way traders in VIX future contracts have piled into bets that volatility will keep dropping (and thus, the stock market will keep rising).

Finally, the price of VIX option contracts have dropped to their lowest level in at least eight years, according to Jason Goepfert at SentimenTrader. Barron's magazine picked up on the story over the weekend, noting that the volatility implied in the prices of one-month, at-the-money VIX options was among the lowest in history. Lower implied volatility in options contracts pushes down their price.

Goepfert has data only going back eight years, but whenever this has happened in the past, the VIX has subsequently moved higher. Of the 45 days when VIX options were as cheap as they are now, the VIX was higher 93 percent of the time, with an average gain of 21%.

In short, the VIX has never been cheaper. That means investors have never felt better.

The same can't be said for the bond market, where high-yield credit spreads have widened (as high-yield bonds are sold), while 10-year U.S. Treasury bond yields have fallen to test the 2.5 percent level for the first time since July (in a sign of growing doubts over the health of the economy.

With the Dow's drop below its 50-day average, after the bulls expended so much energy keeping stock above that level, we're about to see what happens when all that complacency suddenly vanishes.

In response, I am adding the leveraged VelocityShares 2x VIX (TVIX) fund to my Edge Letter Sample Portfolio. A less aggressive play would be the iPath S&P 500 VIX Short-Term Futures (VXX) or simply raising cash in your portfolio. I've also recommended VXX call option positions to my clients.

Disclosure: Anthony has recommended TVIX and VXX call options to his clients.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.