In a year marred by inflation concerns and rising interest rates, Wall Street’s ‘fear gauge’, the Cboe Volatility Index (VIX), has seen a surprising downtrend. According to DataTrek Research, this ‘mysterious shrinking’ of the VIX, a measure of expected volatility in the U.S. stock market, is a bullish indicator for equities, signaling that U.S. stocks are in a bull market despite the economic challenges ahead. This comes as the VIX has dropped over 35% this year and is trading below its long-term average, offering a rare positive sign for stocks in the upcoming months.

However, this seeming calm in the market has left some investors scratching their heads. As Nicholas Colas, co-founder of DataTrek, noted, "At first glance, this makes little sense." With the VIX known as Wall Street’s ‘Fear Index’, one would expect it to reflect the current economic uncertainties, including the recent surge in oil prices and unclear timeline for the Federal Reserve’s elevated interest rates. Yet, despite these potential headwinds, the VIX has remained subdued, suggesting a strong belief in the robustness of U.S. corporate earnings and the assumption that the Federal Reserve’s rate hikes are nearing their end.

The Mysterious Shrinking of Wall Street’s Fear Gauge

Wall Street’s so-called fear gauge, the Cboe Volatility Index (VIX), has seen a surprising decrease this year. The decline, a "mysterious shrinking" to some, is a bullish indicator for equities, says DataTrek Research. This comes despite ongoing concerns about inflation and high-interest rates.

A Bullish Signal Despite Challenges

Nicholas Colas, co-founder of DataTrek, stated that a low VIX is an indicator of a U.S. stock bull market, rather than a sign of delusion about the upcoming challenges. The VIX, which measures 30-day expected volatility of the U.S. stock market, has dropped more than 35% this year. It is currently trading below its long-term average, despite the U.S. benchmark S&P 500 rallying 16% in 2023 through Monday.

Positive Signs Amid Choppiness

On September 14, the VIX hit a "new post-pandemic crisis low," closing below 13. This is a positive sign for stock performance over the next three months, even if it suggests continued near-term choppiness, Colas notes. As of September 20, the VIX closed at 14, significantly below its long-run average of around 20.

Persistent Concerns

Despite this, Colas flags several areas of concern that could potentially dampen investor sentiment. These include uncertainty surrounding inflation, the recent jump in oil prices, and obscurity regarding the duration of the Fed Reserve’s high-interest rate policy. The Fed has been aggressively raising its benchmark rate over the past 18 months in an attempt to slow down rising living costs in the U.S. The recent climb in Treasury rates, with 10-year Treasury yields set to hit new decade-plus highs, has also been weighing on stocks.

A Strong Corporate Picture

Despite these concerns, the ultra-low VIX suggests that none of these issues are significant enough to overshadow a fundamentally strong outlook for U.S. corporate earnings. It implies a belief that the Federal Reserve is largely finished with rate hikes. Equities are dismissing the possibility of a recession over the next one to two years, regardless of what an inverted yield curve, which has historically preceded a recession, might suggest.

Conclusion

The significant decline in the VIX, despite notable economic challenges, is a fascinating development in the financial market. While it signals a bullish equities market, concerns about inflation, oil prices, and interest rates persist. Understanding the implications of these factors is crucial for investors navigating the current financial landscape. Whether the market can maintain its bullishness in the face of these challenges remains to be seen.