Is the stock market’s favorite ‘fear gauge’ signaling more pain ahead for investors?

Investors have endured a lot this year, and it’s not over yet with market technicians debating whether U.S. stocks are embarking on the start of the next bull market, or simply another vicious bear-market rally, as investing titans Stanley Druckenmiller and Michael Burry have warned.

For investors struggling to discern how best to position their portfolios amid a morass of confusing price action and technical signals, one in particular stands out: The Cboe Volatility Index, otherwise known as the VIX
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or the stock market’s “fear gauge,” which this week tumbled back below 20 for the first time since April.

See: Have stocks bottomed? Not until this ‘gorilla’ in equity markets budges, warns BofA

The 20 level for the VIX isn’t only a big, round number. It has significance for Wall Street because it is roughly equivalent to the gauge’s long-term average stretching back to 1990, according to Nicholas Colas, co-founder of DataTrek Research, who spoke with MarketWatch by phone this week.

The low level for the VIX could be interpreted as bullish for those betting on stocks to rally in the months ahead.

What the VIX shows

A key thing to remember is that the VIX measures “unrealized volatility,” an idea that may feel incongruous, given that stocks have been particularly volatile this year.

That also means stock trading can be very volatile, but the VIX still might flash a low level of “fear” because it is pegged to options. This makes it a good indicator of what may come next.

Here’s how it works:

The S&P 500
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has swung by one percentage point or more in 74 trading sessions so far this year — roughly double the average number of such moves recorded between 2013 and 2021, according to Dow Jones Market Data.

However, such swings in the spot S&P 500 index don’t have a direct impact on the VIX. Instead, the level of the VIX is based on moves in the price of S&P 500 options expiring one month out, making it a forward-looking tool (see chart).

This difference also has allowed the VIX to fall lately, while stocks have been relatively volatile — particularly with recent volatility mostly based on moves to the upside.

Is the bottom in?

As when oil prices crashed to zero two years ago, it also matters how futures contracts tied to the VIX trade.

According to Jonathan Krinsky, a technical analyst with BTIG, a peculiar signal didn’t take shape in the VIX despite the historic selloff in stocks in the year’s first half. Unlike in many past corrections, the spot VIX never reached a spread of 10 points with the following month contract. Krinsky’s data shows this was the first time the front end of the VIX futures curve didn’t invert by 10 points or more during a selloff.

“There have been seven meaningful corrections or bear markets since 2004. All of them saw the [VIX futures curve] hit negative 10 or more,” Krinsky told MarketWatch by phone.

Does this mean investors in stocks should brace for more pain? According to Colas, because the VIX traded above 36 at least several times this year, this was probably enough to signal capitulation in retrospect — even if the spot VIX never made it to 40. As Colas pointed out, a VIX of 36 is two standard deviations above the long-term average of 20, which is enough to signal panic.

“We have visited extreme high VIX four times this year, we certainly got to those levels where the VIX is saying something is really, really wrong,” Colas said.

Still, with the fear gauge already back near 20, it “is not where anybody thought we’d be any time soon,” Colas said by phone. “Yet, here we are.”

On Thursday, U.S. stocks pulled back heading into the close, leaving the S&P 500
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to finish at 4,207, down 0.1% on the session. The VIX finished back above 20, closing at 20.20. But the index dropped back below 20 in early trading on Monday as stocks rebounded yet again.

A lull until September?

Then again, a VIX below 20 isn’t exactly a surprise, said Danny Kirsch, head of options at Piper Sandler & Co. Kirsch explained that the lack of event risk on the calendar over roughly the next month will likely help keep the VIX — and perhaps stocks — subdued, for now.

“We’re already through earnings and we don’t have the Fed until September and there’s not another CPI for a month, so there’s a lack of near-term catalysts and the S&P has been rallying,” Kirsch added.

Still, there are some signs of potential trouble further out the curve. VIX futures expiring on Sept. 21, the day the Fed is expected to announce its next interest-rate decision, are trading just shy of 24, a premium of four points to the front-month contract.

Looking out into early next year, the VIX futures curve is relatively elevated heading into next spring and beyond, Kirsch said, despite the fact that the spot level has retreated back below 20 on Friday.

This suggests that volatility traders still see plenty of uncertainty over the next six months — even as traders of Fed funds futures have priced in high odds of interest rate cuts next spring.