Decoding the Fear Index

U.S. stocks are closing in on record highs. But behind the scenes, uneasy investors are keeping their options open. 

They’ve bought gold at a historical pace, boosting the metal’s price to nine-year highs. Same goes for Treasuries, which is why yields are at all-time lows. Lately, we’ve seen that cautious attitude spread to the U.S. options market. A gauge of market worry (the CBOE Volatility Index, or VIX) is stuck at higher-than-average levels, even though stocks are hovering just below their own highs. 

Nobody has a crystal ball for the market, so we can’t definitively say what could be brewing on the horizon. Yet the VIX’s stubborn attitude has caught our attention. It shows there’s growing concern about another pullback in the market. The concern may be misplaced, but we explore some real reasons why the VIX may be elevated below. At the very least, it seems like there could be serious market swings ahead. 

The Market’s Mood Ring 

First, let’s take a quick VIX 101 course. The VIX is calculated using S&P 500 put and call prices, and it’s considered the “fear gauge” of the stock market because it tends to rise when stocks fall (and fall when stocks rise). When the market outlook is uncertain, investors increasingly use options to help limit losses in a market downturn. Think of options as a home insurance policy. You may not need insurance right off the bat, but if there’s a hurricane approaching, you may be more inclined to buy that policy for peace of mind. The VIX is a measure of the demand for insurance against a market hurricane. 

If you want to learn more about options, check out our options terminology & definitions page. Or the Options Playbook. 

We watch the VIX (along with many other indicators) as a gauge of the market’s mood. Generally, we view a VIX higher than 20 as a sign that investors are more anxious than usual. There’s historical evidence to back that up, too, as a VIX above 20 has preceded rockier markets. Since 1990, when the VIX has closed at or above 20, the S&P 500’s average daily trading range over the next month was 1.8% (double the 0.9% range when the VIX has closed below 20). 

Feeling Uneasy 

This year, the VIX has jolted around as the market mood changed from panic to hope. It rose to a record high of 82.69 on March 16, seven days before the stock market hit a bottom, and has dropped significantly since then. 

These days, the VIX seems to have found a floor around 25, no matter how persistent stocks’ rally has been. It’s unusual to see so much “fear” in the options market with stocks this close to a new peak. Since 1990, the VIX has averaged about 15.9 when the S&P 500 has closed within 5% of all-time highs. On Wednesday, the VIX closed at 27.8, its highest level with the S&P 500 within 5% of all-time highs since April 2000. Equity investors seem chill, but the market mood ring may be flashing anxious colors. 

Something seems to be making investors feel nervous, even though the stock market isn’t exactly reflecting it yet. It could be second-quarter earnings season, which is expected to be corporate America’s worst results since the fourth quarter of 2008. We’re less than a month away from Congress deciding on more fiscal stimulus, including enhanced unemployment benefits. Coronavirus hotspots are getting worse, and parts of the economy are closing down again. Technology stocks, which have led the market higher for most of this recovery, seem to be taking a breather.  

In a vacuum, a high VIX doesn’t spell doom. In fact, a rising VIX can be a sign of misplaced fear in an otherwise healthy market. That’s what we saw in most corrections over the last decade – a big spike in the VIX, followed by a ferocious relief rally. But a persistently high VIX combined with worrisome signs everywhere else shows there’s less conviction in the market these days. And if you’re less confident about the market, you may also be less likely to buy the dip if a pullback happens. 

Is this rally for real? 

Not every investor may trade options, but every investor should watch these signals the options market is sending. The feeling of uneasiness in financial markets could be one reason behind the buying exhaustion we keep seeing when the S&P 500 crosses 3,200. 

A stubbornly high VIX has raised some eyebrows, and for valid reasons. In normal times, the VIX and the S&P 500 move in opposite directions: Higher stock prices backed up by improving fundamentals typically boost investors’ confidence. 

Every market recovery is unique, and we don’t base our insight on just one measure. But the VIX falling below 20 is one item on our checklist of things that need to happen before we’re convinced this rally back to highs is for real. 

The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She frequently shares her knowledge as a guest on national news outlets such as CNBC, CNN, Fox Business News, and Bloomberg News. She also serves on the board of Better Investing, a non-profit organization focused on investment education.