Big Decline in Volatility Boosts Stocks—But For How Long?

By Jeff Cox
|  Wednesday, May 20, 2009  |  Updated 10:33 AM PDT
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A sharp decline in the stock volatility gauge has convinced many that fear has left the market, but it's unclear whether investors have gotten the message.

Wall Street was abuzz Tuesday that the Chicago Board Options Exchange's Volatility Index (Chicago: VIX) had dipped below 30, a key psychological barrier whose importance was magnified because the last time the index closed there was prior to the implosion of Lehman Brothers last September.

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As the VIX has plummeted, stocks have soared from their March lows and many on Wall Street are hoping the trend will continue.

"This is certainly a positive for the market," says Quincy Krosby, chief investment strategist at The Hartford. "It's apparent investors believe this market is headed higher at least in the short term, albeit with days that you're going to see the market sell off with a little bit of profit-taking."

Yet there remained concern that even with the VIX hitting lows, the state of the market remains uncertain.

The 30 percent rally off the March lows has come on mostly low volume. Monday's surge of nearly 3 percent across the board saw barely 1.3 billion shares traded on the New York Stock Exchange, numbers associated more closely with mid-summer than the tail end of earnings season.

Volume is traditionally slow in the summertime, and market pros say this year is unlikely to be any different.

"The oxygen for the bulls is volume," Krosby says. In Monday's rally, "The volume was not heavy enough for the bulls to declare an out-and-out victory. The breadth was very good, but for the bulls to declare victory the volume needs to pick up."

There's also the matter of what constitutes low volatility these days.

A year ago, before the financial crisis hit its peak with the fall of Lehman, the VIX closed just above 17. At that point, 20 on the VIX was considered high and 30 was associated with full-bore panic.

But then the VIX zoomed past 80, at one point hitting an intraday high of 89, and the definition of volatility changed. Now, 30 seems benign, but that too could change.

"Investors are tip-toeing back into risky assets," says Lawrence Creatura, equity market strategist and portfolio manager at Federated Clover Capital Advisers. "It's classic in what has occurred in the sense that volatility and risk aversion tend to spike over very short time periods and are only repaired over longer time periods."

The VIX has managed to repair much of the damage since the manic swings of November and March, when investors were filled with uncertainty over President Obama's plans to fix the banking crisis and whether the new White House would be friendly to Wall Street.

Uncertainty, though, takes many forms, and Creatura believes investors still aren't convinced about the state of affairs.

"What I would describe as uncertainty in the market has increased in the scope of different dimensions," he says. "In the housing market we've seen some increase in uncertainty, in the commodities market I think we've seen some increases in uncertainty, and inflation--people are a little less sure of what occurs next."

At the same time, the move in the VIX itself is being greeted with some suspicion and even disdain.

Traders with a shorter-term view of the market actually like volatility—within reasonable limits. Swings in stock prices present chances for nimble investors to move in and out of positions and make money.

Options traders had been betting heavily against a rise in VIX gains, and Wednesday's futures contract expiration will spell bad news for many of them.

Of the more than 2.1 million VIX contracts expiring tomorrow, more than a third are calls, or bets that the index was going higher. And most of them will expire out of the money, according to an analysis from Interactive Brokers.

With the VIX moving lower, traders could get caught in another trap, the firm said.

"This brief analysis highlights the springboard rally for stocks as overly pessimistic conditions fade," Interactive Brokers said in a note to clients. "As they do, watch for investors to overdo the volatility decline. As we keep noting, we're still not out of the woods yet."

As for the market, though, the lack of volume combined with the air coming out of the VIX could mean good things.

A debate has raged over whether the stock gains have been the product of a bear market rally or if there's something more long-term afoot.

"I almost see (the low volume) as a positive because it shows there's not overwhelming optimism in the market. That means its' not being overdone," says Richard Sparks, senior analyst at Schaeffer's Investment Research in Cincinnati. "Not everyone is buying in yet and not everyone is on the bandwagon. That's part of the reason why (the rally is) so sustainable."

For more stories from CNBC, go to cnbc.com.

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