After last Thursday's volatility surge, driven by the horrific missile strike against Malaysia Airlines flight MH17 and fresh violence between Israel and the Palestinians, the stock market has calmed down. Large cap issues in particularly seem largely unfazed by all this, with the Dow Jones Industrial Average not suffering a meaningful close below its 20-day moving average since April.
Moreover, the Dow finished last Friday with its 11th straight weekly gain — the second longest winning streak of the bull market to date. Bidding stocks up into the weekend is a classic sign of confidence, since it assumes that nothing will go wrong in during the two days the market is closed.
The CBOE Volatility Index (VIX), which measures current market volatility or fear, spiked last Thursday but has fallen since then and remains at levels well below its long-run average. But beneath the surface, the evidence is building that insiders are hunkering down for a period of turmoil on a scale that, on one measure, has never been seen before.
This can be seen in the way the S&P 500 SKEW index, which measures how aggressively investors are buying up protection against a big potential downside move, has been pushing higher over the last few weeks.
The SKEW is calculated similarly to the VIX, as both are based on the contract price of S&P 500 options. But the SKEW differs in that it's based on out-of-the-money put options. When the SKEW rises, it reflects a rising probability of a large negative performance in the stock market. If you can visualize a standard "bell curve" probability distribution, a higher SKEW means that traders believe the left tail of the bell curve is growing.
One way to interpret this is that while most investors are very, very complacent now, many are growing more fearful about the future. In other words, fears of a "Black Swan" event are increasing.
In fact, the gap between the SKEW and the VIX blew out to a new record high earlier this month (just before the Fourth of July holiday, another end-of-week surge) and remains very extended at levels last seen in 1990, before a 17 percent correction, and in early 2006, ahead of a big volatility blowout.
Jason Goepfert from SentimenTrader, in an e-mail exchange, had this to say about the SKEW:
"It appears as though traders are pricing in the highest-ever 'tail risk' relative to overall volatility levels. There is high demand for out-of-the-money put options and not so much at-the-money options. It could be argued that this is a contrary indicator, the theory being that if traders are so worried about a Black Swan, it's less likely to happen. But the history of the SKEW, especially over the past five years, has shown that not to be the case. When the SKEW was very high, stocks were more likely to fall."