Is VIX Signaling Complacency -- or Sell-Off Fatigue?

What if they threw a market sell-off and no one seemed to care? We've gotten that a bit recently. This, from Bloomberg:

"While U.S. stocks keep falling, an index that's supposed to track investor angst is behaving as if it's just another day in the market. What's going on?

The Chicago Board Options Exchange Volatility Index climbed to 16 as the S&P 500 lost 3 percent from a record high on March 2, the second-lowest VIX level for a stock decline of that size since March 2007. Compare that to the previous six years: on average when the stock gauge dipped that much, it pushed the VIX to 30."

I'd question the metric a bit. I'd rather see what the CBOE Volatility Index (VIX) does on a percentage basis in "X" market dip. In the fall of 2008, for example, 30 was a bottom for VIX, not a spike high. Over the long course, VIX averages about seven times the market move, so a 1% drop in the S&P 500 Index (SPX) would result in about a 7% pop in VIX. But, it's important to note that it's really a linear relationship, so a 1% market drop probably leads to a larger pop in VIX.

So, while I don't agree with the metric, I do agree with the general conclusion. If you told me we were dropping 3% in something like a week, I would have anticipated more of a VIX pop. But don't forget, we're coming from a low basis and a very low realized volatility. Maybe we're talking something like 18 VIX. But in all fairness, if we got there, VIX would have gone over the Bollinger Bands and 20% over the 10-day simple moving average, and I would have said we got overbought. VIX at 16 is kind of neither here nor there. It's certainly not fat, but it's not particularly low either. And I believe a lot has to do with this:

"'When you have so many of these mini-selloffs, and we rebound to new highs, you probably do have some people that have been worried in the short-term and the worry hasn't been justified,' Russell Rhoads, senior instructor with the Options Institute at the CBOE, said by phone. 'So they try to hedge a little bit longer term and be less reactive.'"

Very much yes. We've just seen this movie too often over the past 15 months or so: We grind to new highs, then all of a sudden we get an ugly stretch and we get bombarded with all sorts of "reasons" why the bull is now done. Right now it's the dollar, with a whiff of Fed. But time and time again, we quickly discount the news and resume the grind higher.

Buyers of doom and gloom scenarios lose again and again -- and, being humans and all, get a little wary before bidding up for protection the next go around. This cycle won't last forever, of course. One time we collectively will prove too disinterested in a current market worry and will get burned. It's very tough to know which time that happens. Who knows; maybe it's now. If the Fed removes the word "patience," Armageddon could follow. (I'd be shocked if we actually top on something like that).

I do want to remind everyone, though, that timing complacency is extraordinarily difficult. We'll top on complacency, but you'd get so many false signals before then that it's not really worth trying to game it.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.