By Saqib Iqbal Ahmed
NEW YORK (Reuters) - The last two weeks in the U.S. stock market have been quiet - almost too quiet for some investors, who think there's something dangerous swimming beneath the surface.
After a disastrous start to the year, major U.S. indexes regained most of the losses in a mid-February-to-mid-March rebound. Volatility measures collapsed as the S&P 500 rose to levels not seen since the beginning of 2016 and the market entered a period of calm not seen since early December.
But there are growing expectations that volatility could return fast. Investors have pushed up the cost of protection. Bets on a rally in stocks are cheap, and investors are pouring money into volatility funds that profit when stocks tank.
"Everybody feels a bit skeptical about the recent calm," said David Miller, portfolio manager of Catalyst Macro Strategy Fund, which trades options on individual securities, international exchange-traded funds, and VIX ETFs.
"You can really see that expressed in the VIX futures market," Miller said.
The CBOE Volatility Index (VIX), or the VIX, the most widely followed gauge of investor uncertainty, has lingered below its long-term average of 20 for 19 days. On Tuesday, the VIX was down 2 percent to 14.93.
On March 18, with the VIX dropping sharply, the gap between the VIX cash index and the front-month VIX futures widened to the most since August 2012, a sign investors have much greater concern about the future than the present. On Tuesday, VIX April futures (VXc1) were at 17, so that gap has narrowed.
While there are many worrisome factors, including another interest rate hike from the U.S. Federal Reserve or another sharp drop in oil prices, traders see the coming corporate earnings season as their biggest concern.
"We have had such a violent rally, led by sectors where sentiment was previously extremely negative and continues to be negative," said Alex Kosoglyadov, director of equity derivatives at BMO Capital Markets.
Kosoglyadov pointed to the outperformance of metals, mining and industrial shares - moves that suggest short-covering rather than a fundamental re-evaluation of the markets. The recent sharp rally means that investors are not as well protected against a sharp drop in stocks as they were a month ago.
Another soft quarter could rein in these sectors. S&P 500 earnings are forecast to fall 6.9 percent in the first quarter from a year ago, much worse than the Jan. 1 forecast for an earnings gain of 2.3 percent, according to Thomson Reuters data.
Traders in the options market have responded to this threat by pushing up the cost of protection. Relative to calls, the price of 90-day SPX puts is higher than about 90 percent of the readings over the last 52 weeks, according to options analytics firm Trade Alert.
Traders have also taken a fancy to products that bet on big swings in the market. Those include the iPath S&P 500 VIX Short-Term Futures ETN (P:VXX) and the ProShares Ultra VIX Short-Term Futures ETF (P:UVXY), a leveraged fund. Net exposure to exchange-traded products tied to volatility surged to its largest net long position in about 10 months, analysts at JPMorgan (NYSE:JPM) said in a note on Tuesday.
Investors have bought a net $3.5 billion worth of VIX futures over the last month in bets that the futures tracking the VIX will rise, according to Nick Cherney, head of exchange traded products at Janus Capital Group. That is the most ever for a month and shows investors are gearing for increased stock gyrations.
With the S&P 500 trading at around 17 times expected earnings, some market strategists think such valuations can only be sustained with strong earnings results and not many believe that is likely.
"I don't think it's a time to incur a large amount of risk by selling straddles or strangles," said Dan Deming, managing director at KKM Financial, referring to popular strategies that bank on muted volatility.
In contrast, the contraction in volatility does make for an attractive opportunity to buy sector ETF hedges, BMO's Kosoglyadov said. Stock replacements - replacing a long position in stocks with upside calls - also appear attractive, he said.