Fear and greed are both rallying in 2014.
Both the VIX, the so called “fear index,” and stocks, let’s call it the “greed index,” are up in 2014. Typically, these two indexes move inversely to each other, which makes sense. Stocks tend to rally when investors feel secure and fall when they’re scared. In simple terms, the VIX measures the cost of insuring stocks. The greater the fear, the more investors are willing to pay to protect their portfolios, which explains why the VIX rises during turbulent times.
So what gives? And more importantly, what does that mean for stocks?
(Watch: Market can now focus on economic news: Pro)
“Look out below,” said Gina Sanchez of Chantico Global. “This cannot continue to last. If you look at the P/E expansion at this point in the rally, what it says is that are really optimistic about future growth. It’s hard to justify being this exuberant. And the VIX moving up basically says they’re going to wake up.”
Other market participants point instead to the Fed, or more specifically, the taper as one reason for the increase in volatility.
The implicit promise of a Fed backstop has emboldened investors to take risks in the last couple years. The strategy is simple: if the Fed keeps printing money, buy stocks and ask questions later. Many traders refer to this as the “Fed put.” But with the reduction of Fed stimulus, traders are starting to question that approach.
(Read more: How to deal with rates, step by step)
“The market believes the strike price for the “Fed put” is now lower than it used to be,” wrote Nicholas Colas, Chief Market Strategist at ConvergEx Group, a global brokerage company based in New York. “The Fed will need to see stocks drop quite considerably before they reverse course and open the QE spigots once again.”
Put simply, the increase in the VIX could be the options markets way of pricing in the taper. In the absence of a so-called “Fed put,” investors are instead buying real puts, and that’s causing the VIX to rise when it would normally fall in a raging bull market.
So what should investors do?
“I think being long volatility could be the surprise trade of the year,” said Brian Kelly of Kelly Capital Management.