Here's how the stock market's fear gauge can signal whether a bubble is forming (2024)

• As tech stocks march to new all-time highs amid rising COVID-19 cases in the US, investors are questioning whether a speculative bubble in stocks may be forming.
• Nicholas Colas, co-founder of DataTrek Research, said on Tuesday that investors can look at the level of the VIX, also known as the fear index, to determine if stocks are in a speculative bubble.
• Colas highlighted that near the peak of the the dot-com bubble, the VIX had an average reading of 24.95, relative to its since-inception average reading of 19.8, according to historical data.
• Colas said as long as the VIX trends lower to below the 20 level, the stock market is not in a bubble.
• The VIX registered a reading of 24.46 on Tuesday, falling 70% from its peak of 80.85 in mid-March.
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As mega-cap tech continues to command an ever-growing share of the S&P 500's total market value, and as the Nasdaq 100 index hits new highs amid rising COVID-19 cases in the US, investors are wondering if a speculative bubble in stocks is forming.

Nicholas Colas, co-founder of DataTrek Research, said in a note on Tuesday that investors can look to the VIX, also known as the fear index, to identify whether stocks are in a bubble or not.

The VIX is an index that helps measure volatility in the markets. A rising VIX is indicative of falling stock prices, while a falling VIX usually indicates rising stock prices.

For example, as the S&P 500 dropped 35% from its peak in mid-February to its bottom in mid-March, the VIX index surged 425% to 80.85. Now, as stocks have clawed back and recovered most of their losses, the VIX has dropped 70% from its peak to 24.46 on Tuesday.

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According to Colas, the current reading of the VIX relative to its historical average "would seem to be reason to think the rally can continue."

Colas explained that the average level of the VIX since its inception in 1990 is 19.4, with a standard deviation of 8.1. Meaning that Tuesday's VIX level of 24.46 is within one standard deviation of its historical average.

This indicates "that the options market thinks we are not set up for another bout of market volatility in the near future," said Colas.

To understand whether today's market is in a tech-driven bubble like it was back in 2000, Colas looks at the historical VIX readings from 1997 to 2000, which was an "unusual period of market history."

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Then, the average VIX reading was reliably above 20, with the S&P 500 delivering returns of 33.1%, 28.3%, and 20.9% in 1997, 1998, and 1999, respectively.

But the main difference between then and now is that now a handful of extremely profitable mega-tech companies "dominate important verticals and provide market leadership rather than the free-for-all that drove stock prices higher during the late 1990s dot com bubble," Colas observed.

For Colas, it makes sense for investors to believe that a bubble in stocks is forming if the VIX stays mostly above the 20 level. But if the VIX falls below 20, it's safe to say we are in a low volatility environment that isn't indicative of a speculative stock market bubble.

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And even if the VIX stays elevated above 20, don't rush to sell your stocks, the note said. "This won't be a sell signal, just as it wasn't in 1997. But it will be a sign that we're in a different sort of market from the ones we usually see after a crisis," Colas highlighted.

Justifying large-cap tech's impressive year-to-date rally, Colas said, "There have been 10 turns of Moore's Law since the year 2000, but those in conjunction with the disruption wrought by COVID-19 may finally be delivering the tech-driven world many imagined in 1999."

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