Futures Outlook - An Excerpt from CRB'S Futures Market Service

Stock market volatility falls to 8-1/2 month low but stock market risks remain relatively high

The VIX index on Thursday, June 25, fell to a new 8-1/2 month low of 26.30%, the lowest level seen since mid-September 2008 when the global financial crisis kicked into high gear with the bankruptcy of Lehman Brothers. The Chicago Board of Options Exchange SPX Volatility Index (VIX) is a weighted average of implied volatilities for the first two option months and is therefore a measure of expected volatility of the stock market over the next 2 months.

The new 8-1/2 month low in the VIX index indicates that the market is becoming more confident that there will not be a new melt-down in the US stock market. The VIX index typically soars when stock market prices fall sharply since put sellers become scarce due to the high risk of writing insurance against a large market decline. On the flip side, the VIX index typically moves lower when the stock market prices are moving sideways or higher.

However, the VIX index is also somewhat of a contrary indicator in the sense that a low VIX volatility figure can suggest a level of complacency in the marketplace and the increased chance for a sell-off that catches the market off guard. In that sense, there are still plenty of things that could go wrong for the US stock market. First, the market seems to be fairly optimistic that the US recession will end before year-end. Yet there is no assurance that the recession will end or that there will be a recovery of any substance given that the US housing and labor markets appear set to decline into 2010 and given that many US consumers will remain “wealth challenged” for perhaps years to come due to high debt and low home prices. Second, there is still the risk of a new financial blow-up, either at a major financial institution or in a market such as credit default swaps, commercial mortgage securities, etc. Third, there is the outside possibility of a dollar melt-down given the Fed’s extraordinarily stimulative monetary policy. Fourth, earnings may remain damaged for much longer than the market expects. The decline in the VIX index could turn out to mean that the market is letting down its guard when it should be maintaining relatively high risk levels to account for the multitude of things that could still go wrong.

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